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Tue, 06 Jan 2015 16:18:11 +0000en-UShourly1http://wordpress.org/?v=4.1Yellenizationhttp://www.excelsia.com/2014/08/yellenization/
http://www.excelsia.com/2014/08/yellenization/#commentsThu, 07 Aug 2014 21:49:22 +0000http://www.excelsia.com/?p=1308I turned to look but it was gone I cannot put my finger on it now The child is grown, The dream is gone. I have become comfortably numb.

– Pink Floyd

On Thursday, July 31st, the market had a one-day sell-off of 2%, the most negative day since June, 2012. You heard the market pundits and the talking heads of CNBC opine that the reason for the selloff was the convergence of geopolitical risks:

Increased tensions between Western governments and Russia, exacerbated by the events of the last two weeks in Ukraine; additional sanctions forthcoming.

The escalating conflict between Israel and Hamas in Gaza that is beginning to be a catalyst for a larger Muslim versus Judeo-Christian conflict in the Middle East.

Argentina’s “technical” default on debt payments. This is the ninth such default since Argentina first issued bonds in 1824; nothing new here other than a hedge fund and a judge.

The largest Ebola outbreak ever in Africa, which put health authorities across the globe on high alert.

The renewed “contagion risk” that a Portuguese bank imposes on the rest of Europe if it defaults.

The attempt of ISIS in Iraq to install a caliphate that would impose Sharia law on the territories it controls, thus allowing Abu Bakr al-Baghdadi to rule with the same sort of dictatorial hand Saddam Hussein (and you thought he was a bad guy) wielded for twenty-four years. All in the name of Allah, of course.

While all of these are valid concerns and could be viewed as reasons for a stock market decline, I contend that they had very little effect on investors, save those trading in the oil markets.

Thirty-four years ago when I began my career, any of these geopolitical risks would have been enough to send the markets into a temporary tailspin. There was no CNN, Twitter, Facebook, or smart phones to keep the ills of the world constantly on our minds. We had Walter Cronkite, with his memorable signoff, “And that’s the way it is,” to inform us of geopolitical events, and without the graphic camera footage we see today.

In today’s world we drink global news events from the fire hoses of smart phones, 24-7 television coverage from multiple networks, blogs, Twitter, Facebook, and various other media. The constant barrage of horrors inflicted by human beings on other human beings, graphically reported by a widening array of media over the past fifteen years, has, in my opinion, ultimately served to numb investors and the public at large. We’ve had to digest those horrors and fold them into our understanding of how the world works. I am never amazed anymore at how ready and willing some are to take lives in their struggle against whatever supposedly oppresses them, whether their reasons are political, economic, or religious.

The face of war changed after the fall of the Berlin Wall in 1989. It is possible to wage war strategically against an enemy nation that poses a defined target, but decentralized terrorist groups such as Al-Qaeda can orchestrate conflict by means of vast numbers of cells scattered across Africa, the Middle East, and – lest we forget 9/11 – here in the USA. How do you fight a war where the enemy is constantly shifting and hard to find? I wrote in 2013 that we live in a G-zero world where we lack any one government’s leadership to prevent continued destruction. Russia flexing its muscle in Ukraine, China and Japan fighting over territory in the East China Sea, everyone fighting everyone else in the Middle East are just examples of our new world order. But to make the leap from global tensions to market sell-offs is a big jump; after all, these events have been going on for some time.

The market sell-off last Thursday, in my opinion, had more to do with economic risks presented by the end of Fed tapering and the possibility of higher interest rates. If you assess the likely impact of the Fed’s tapering course, keeping in mind the fact that we have not experienced a market correction of more than 10% since 2011, then predicting some type of correction in 2014 was a pretty safe bet at the first of the year.

In April’s letter I wrote the following:

The Fed is currently purchasing assets and creating money at a rate of $55 billion per month. At the $20 billion mark tapering gets real; and as Dr. Fisher indicates, he anticipates QE3 to end sometime this fall. But will QE programs and Federal Reserve intervention ever truly end?

The markets have become addicted to their investment cocaine, and once the supply is cut off, then cold turkey withdrawal ensues. In my opinion, when the pain becomes too great and the powers that be start catching heat, then Dr. Yellen and Company will see their tapering plans torn up like a Walmart tent in a tornado.

The US is not in economic decline. We are still the most vibrant economy in the world, driven in the present era by increasingly abundant energy and game-changing technologies, including biotech and nanotech. And we are a country rich in natural resources, particularly farm land and water. Despite Washington’s efforts to curtail our progress with a badly functioning healthcare law, deterioration in our education system, and reluctance to reinvest in infrastructure, our government has yet to derail the train of corporate investment and small-business entrepreneurship. We are now in the 60th month of a recovery that compares to an average of 95 months for recovery periods over the past three decades. Admittedly this recovery lacks the robustness of recoveries past, but nevertheless we continue to “muddle thru” with positive results. The Achilles heel of our recovery has been the explosion of the Federal Reserve’s balance sheet following the 2008 crisis and runaway deficits due our dependence on government spending for economic stability.

It appears that Europe and the UK, while slowing, are also still in positive GDP growth territory. I have voiced concerns in the past over the need for a central bank for the euro. Whether EU countries have the economic fortitude to let Germany dictate terms for forming the equivalent of our Federal Reserve remains to be seen. However, the convergence in thinking between German Chancellor Merkel, ECB President Mario Draghi, and other European central bankers would lead one to believe Europe will continue its course towards the formation of a central bank. In the interim Europe’s economy will be without reform or recovery, but we will not see a Eurozone collapse or even another crisis. Whereas the US is “muddle through,” Europe is “stuck in the mud.”

So, if the developed nations’ corporations are continuing to grow earnings and interest rates currently remain low, then what could cause a correction in the market as initiated by July’s sell-off – or worse yet, a bear market? The answers:

The China banking mystery

Emerging market deleveraging and corporate restructuring

Unintended consequences of the Fed’s tapering

China – What is Going On?

For one, there’s a new sheriff in town, and the Central Discipline Inspection Commission (CDIC) is not hesitating to remove high-level government and state officials under the charge of corruption. This strategy of using anticorruption sanctions is an effort to intimidate reform opponents within the party as China enters a new era of economic and political reform. To date, 33 high-level officials have been investigated for violating laws, the latest being Zhou Yongkang, formerly a member of the all-powerful Politburo Standing Committee and head of China’s security. People like Mr. Zhou were thought to be untouchable, but with his ouster President Xi has left no doubt as to who is ruling China. And with his power he is pushing reforms long overdue in order to sustain the government, reduce the power of the party, and implement banking and economic reforms while simultaneously consolidating governance at the top.

As for China’s economy, I must admit that the anticipated break down either by a loss of control in their banking system or social upheaval has not happened during the last decade of unprecedented growth. However, the lack of transparency of the Chinese financial system makes their role in the global economy suspect. The biggest risks to the Chinese economy lie in the financial sector, where government mandated construction projects and the need to employ millions of people have jeopardized bank solvency and raised the specter of defaults. Consider the following chart:

That’s a lot of cement!!! Where did it go and what was it used for? I have read articles about “empty cities” and watched 60 Minutes televise segments about entire towns full of thousands upon thousands of new apartments and condos where no one lives – ghost towns owned by middle class Chinese who, like US real estate investors, thought real estate was a safe investment because prices had never declined. The Chinese use their savings and borrow money to buy as investments not one or two but multiple apartment units that are not occupied. President Xi is being forced to reduce the moral hazard in the banking community and make clear what the central government is going to guarantee and what it isn’t. With more than $4 trillion in surplus, it is possible to proceed smoothly, although GDP will probably decline below the current 7.5% growth rate. The challenge is to prevent a consolidation of industrial production that eliminates jobs and to simultaneously avoid some form of financial crisis. Without a doubt there will be industries that go out of business, officials thrown in jail, and more government regulations forthcoming in attempts to negotiate a “soft landing” versus a “hard landing.” China is competing in the early innings of a ball game fraught with global consequences, and much of the trouble they face now and the risk they pose to the global financial system derives from a lack of transparency in their banking system.

Emerging Markets Restructuring

We used to say that if the US economy caught a cold, the rest of the world caught the flu. China, as the world’s #2 economy, has now reached a position where if it catches a cold, a large portion of the emerging markets catch the flu. Countries such as Brazil, Indonesia, Turkey, Russia, and others depend on China’s purchasing of their natural resources as a big part of their ongoing economies. Add to the potential China slowdown the fact that South Africa, Turkey, Indonesia, India, Colombia, and Brazil all face elections with no one party in a position to provide effective leadership, and you have the makings of a very bumpy ride in emerging market stocks in the near term. During the 1990s and 2000s, when the developed economies were expanding, the US provided the fuel for emerging market growth. Today that is no longer the case, as evidenced by the stagflation seen in many EM countries. Private-company debt has risen from an average rate of 14–16% to today’s 18-20%. Inflation in many of these countries is approaching double digits; and without the emergence of their middle class to stimulate consumption, many corporations will need to deleverage balance sheets and restructure debt. I see an opportunity here for firms such as KKR and the Blackstone Group to provide the capital needed to facilitate EM debt restructuring. We don’t own either of these companies, but they and other beneficiaries of emerging market debt restructuring are on our radar.

The Fed, Tapering and Government

What about this chart doesn’t look right? Is it oil? Is it home prices? Or is it the CPI relative to real living expenses? I contend that since the crisis of 2008 the silent killer of purchasing power in the US has been the unseen hand of inflation that the Fed wields with its massive printing of money. Combine the past fifteen years of decreasing purchasing power with the Fed’s zero-interest-rate policy, and you get as an unintended consequence an economic system that robs the poor and gives to the rich. Maintaining interest rates at unprecedentedly low levels for an extended period of time has caused investors to take risks they ordinarily would not take. Investors have shifted from “safe” investments to riskier financial assets and real estate because they can earn little to nothing in “safe” investments.

Some say stock prices are in a bubble; however, given the strength of earnings, dividend growth, share buybacks, a “muddle thru” GDP, and few if any alternatives to stocks, the market looks fairly valued to me. The average wage earner could not take advantage of the market move from 2009 to the present, and we see the effects in the chart below on the quintiles of wealth distribution in America. Continued Fed policies will continue to drive greater wealth to the top 5%, who already own the majority of the investable universe. The middle and lower classes will continue to become poorer.

The chart above shows that every income group still lags behind where it used to be, on average. The top 5% of households, for instance, have an average net worth now of about $1.4 million — but that’s still about 16% lower than in 2007. The top 10% have an average net worth of about $763,000, down about 18%. Yet that’s far better than the median household, which has lost about 43% of its net worth since 2007.

Summary

“May the odds be with you.” –The Hunger Games

As former heavyweight champion Mike Tyson put it, “Everybody has a plan until they get hit in the face.” I am not a Mike Tyson fan, but his point raises the question: what’s your investment plan? How do you manage risk in your investments? Do you have an investment discipline? How are you going to handle the market’s punching you in the face?

The following chart lists some of the sharper corrections from 1982 to 2014; now consider: what is your plan if the market declines 15-20% between now and year’s end?

I am not predicting that a market decline is certainly on the horizon; however, our asset allocation work at the end of June prompted us to raise our cash position from 4-5% to 11-12% during July. There is nothing cheap in the US large and small equity markets. Europe is enticing; but until Mario Draghi and the euro countries come to terms on a central bank plan, we will limit our exposure to the EU. Long-term we understand the need to participate in emerging markets, but given the risks posed by China, along with potential restructuring, we will be cautious.

We still recommend hard assets, particularly if Janet Yellen and company stick to their guns on tapering, as rising rates would appear to be the result of their actions. We include in hard assets oil and gas, mining, real estate, pipeline MLPs, and infrastructure. GDP will contiue to be the dominant fundamental for stocks, and a continued “muddle thru” environment would indicate more room to go on the runway of stock appreciation.

Because of the increasing odds of a market pullback and a possible disaster in the domestic bond market, we have increased our use of “liquid alternative” strategies in our portfolios. Institutional investment management tools are now available to smaller investors; and we can efficently gain exposure to mezzanine debt, private equity, long/short equity, long/short credit, and event-driven investment strategies. If you have not heard of liquid alternatives and are wondering how to utilize them to mitigate risk in your investments, then contact me and let’s get you up to speed on how these investments are defined and how they work.

“I’ve learned that people will forget what you said, people will forget what you did, but people will never forget how you made them feel.”

–Maya Angelou: April 4, 1928 – May 28, 2014

Good luck out there. Cliff

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Excelsia, Inc. is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.

]]>http://www.excelsia.com/2014/08/yellenization/feed/0Echo-Mania at The Fedhttp://www.excelsia.com/2014/04/echo-mania-at-the-fed/
http://www.excelsia.com/2014/04/echo-mania-at-the-fed/#commentsTue, 15 Apr 2014 21:09:07 +0000http://www.excelsia.com/?p=1272“Get your facts first, then you can distort them as you please.”
– Mark Twain

“The beat goes on, the beat goes on
Drums keep pounding
A rhythm to the brain
La de da de de, la de da de da” – Sonny Bono

“Just because everything is different does not mean anything has changed.” – Irene Peter

Greetings from a thawed out Savannah! Q1 of 2014 will be remembered for a number of things, but the most prominent were the erratic weather patterns and arctic-blast temperatures that most of the country experienced. I missed writing my Q1 letter for the first time in ten years due to a nasty bout with pneumonia in mid-January. For those of you who have never had pneumonia, I do not recommend it! However, one of the outcomes of my illness was that our readers missed my first-of-the-year prognostications, which is probably a good thing, as I have always found those annual predictions make you look far smarter or dumber than you deserve. However, time waits for no one, and for the remainder of the year we are focused on the following:

Vladimir Stepping Over the Line

Affordable Care Act Gone Wild

China – What to Believe

Japan and Currency War

The Fed Is All That Matters

Vladimir Stepping Over the Line

Vladimir: You draw line in sand with Syria?
Barack: Yes.
Vladimir: And Syrians step over line?
Barack: Yes.
Vladimir: And America does nothing to enforce line?
Barack: Yes.
Vladimir: Ummmm… We take back Ukraine.

On March 3rd, Russia decided to take back a piece of the mother country and essentially invaded Ukraine. This international military action should act as a stimulant to the defense industry and comes just in time, as the US Congress is debating cuts in defense spending. Tax dollars will flow needlessly to build aircraft, cruise missiles, drones, and other defense weapons. In my opinion, Americans have grown weary of supporting the US as the policeman of the world. And frankly, most of the world has tired of the US trying to enforce its will in foreign lands where we are seen as the problem and not the solution. Vietnam, Iran, Iraq, Syria, and Afghanistan have proven to be US policy and military failures, as conventional wars are being replaced by cyberwarfare and terrorism. Americans want to see the billions of dollars that are currently being spent overseas diverted back home to fix roads, maintain other critical infrastructure, and fund schools that effectively prepare graduates for 21st century jobs, spurring economic growth in the USA.

From the graph above it is clear to me that in order to attack US budget woes, cutting defense and letting the rest of the world fight their own battles is in our best interest. The recent events in Syria and now the Ukraine have exposed the underbelly of the US military and our inability to take on multiple police actions in foreign lands. Invasions of foreign lands have a poor track record of restoring order in countries with a history of despotism and dictatorship. As painful as it is to watch the citizens of an Egpyt or Iraq take years to choose and elect their form of government, US intervention only puts a band-aid on a flesh wound and earns us a bad rap in the eyes of the world.

Medicare, Social Security, and national defense are inefficient and unsustainable in their current forms. If the US is going to become a fiscally responsible country again, then conservatives need to stop pretending defense can’t be touched, and liberals need to cease their wailing over entitlement programs.

“But each proposal must be weighed in light of a broader consideration; the need to maintain balance in and among national programs – balance between the private and the public economy, balance between the cost and hoped for advantages – balance between the clearly necessary and the comfortably desirable; balance between our essential requirements as a nation and the duties imposed by the nation upon the individual; balance between the actions of the moment and the national welfare of the future. Good judgment seeks balance and progress; lack of it eventually finds imbalance and frustration.” – President Eisenhower

The Un-Affordable Care Act

What have I learned during 2014 tax season? Virtually every Excelsia client has commented they are paying more taxes this year than last, and the reason: ObamaCare, 3.8%. Healthcare costs continue to escalate. The combination of Baby Boomers entering retirement and thus drawing benefits from Medicare and Medicaid and the already-retired living longer makes the current system unaffordable. In 1967, when Congress originally forecast the long-term costs of Medicare, they thought that in 1990 Medicare would cost taxpayers $12 billion. The actual cost in 1990 was $110 billion. I predict that we are in for a similar fate with the Affordable Care Act, due to the following factors:

No risk premium is being paid for pre-existing conditions.

No risk premiums are paid for age.

Many among the healthy and the young are opting not to enroll in the program.

An unhappy populace that knows they were deceived with the promise that they could keep their existing healthcare plans will vote for change in 2014.

My son is 22 years old, a student in accounting at Georgia State who last year earned just under $9,000 while working and going to school. He is faced with paying a monthly premium of $300 to be insured under the Affordable Care Act. His response to me:

“Why should I pay over $3,600 a year for insurance? I am young, healthy, and rarely go to a doctor. And if I do get sick or have a serious illness that requires hospitalization, then because I can’t be refused insurance for pre-existing conditions, I will go buy the insurance coverage if I need it.”

The Achilles heel of ObamaCare will be the failure to convince the population under the age of 35 to enroll and pay premiums. Add to lackluster enrollment the costs of covering pre-existing conditions as if they didn’t exist, and I fear our government has created a monster that resembles the vicious blood-sucking plant in Little Shop of Horrors: “Feed me, Seymour!” But what will we feed the Un-Affordable Care Act when premiums fail to cover claims and tax revenues decrease as more Americans try to control their level of taxable income in order to qualify for insurance subsidies? Why, more Fed-printed money of course!

From an investment perspective, we continue to see the Affordable Care Act as an impediment to business hiring and GDP growth. Corporate investment for future expansion will remain on hold until the CEOs and CFOs along with their boards have some assurance as to what their future liabilities will be under the Affordable Care Act.

“We have to pass the healthcare bill so you can find out what is in it.”
– Nancy Pelosi

American business is still trying to find out what’s in it!

Peering Over the Great Wall

What can we believe is going on in China? We read reports of impending loan defaults, a potential credit crunch, and possible contagion chaos in banking from failed derivative trades, all or any of which could cause another major financial crisis. I have seen the pictures of empty cities, the contamination of water supplies, and the ever-present air pollution. But what are we to believe?

After the Chinese government allowed its currency to appreciate for most of 2013, the yuan collapsed in February of 2014, probably in response to declining Q1 China GDP numbers. I view the slowdown in China as a positive, not a negative, because China’s leadership is demonstrating a commitment to move to a more balanced and sustainable growth model as opposed to the current borrowing and investing in order to prop up growth. The short-term borrow-and-invest approach works for a while, up until debt rises out of control and investments become less productive. As illustrated in the graph above, credit in China held steady at 130 percent of GDP for much of the 2000s. However, post-2008 it has shot up to nearly 200% of GDP, which is an increase of 55% in five years.

Not surprisingly, there has been a highly energized building boom over the past decade in China, with a tsunami of credit flowing into the system. Question is, will the government back the financial sector once the growth eases and defaults mount? There is a phrase in banking: “A rolling loan gathers no loss.” The question is, how much longer can Chinese private banking roll the economy? And more importantly, will the government continue the reforms needed to stabilize the country’s growth? The chart below shows the value of the yuan versus the dollar over the last year. China’s leadership obviously thinks a cheaper yuan is in the best interests of China.

China will no doubt be the largest economy in the world by 2030 if it can avoid a catastophic event in its financial markets. The recent move by the central bank to cheapen the currency has convinced traders that the Chinese economy will strengthen, emerging countries will avoid a crisis, and global growth will continue. However, I think China will need more than a cheaper currency to cure its leveraged financial balance sheets, because the quantity of potentially bad loans is simply too large. The central bank of China knows that it cannot bail out every company, and for the first time we are seeing bankruptcies of companies. We will steer clear of the China story in our investments and will remain keenly aware of the potential ramifications of any China crisis.

Japan: No Free Lunch

In September 2012 Abenomics was born, with the purpose of increasing Japanese inflation to 2% and devaluing the yen versus all other currencies. Today Japan faces a mountain of debt, with a debt-to-GDP ratio that reached 224% at the end of 2013.

With Japan’s birth rate below replacement level and a cultural resistance to immigration, it is easy to see that domestic demand for goods and services is going to decline in the coming years. Japan’s only hope for economic growth is to become a larger export economy. Rather than relying on innovation as an economic driver, the finance minister is going to compete on price. By lowering the yen, he is trying to make the price of a Lexus equal that of a Kia in US dollars. The huge amount of money creation in Japan is much larger than that in either the US or Europe. The intent is to fuel the economy with cheap yen, increased exports, and an appreciating stock market. In my opinion the party ended when Abe and Company increased the sales tax from 5% to 8%, effective April 1. The sales tax effectively kills the positive effects of QE in Japan. The thrill is gone, the pain begins, and I predict Japan is destined to repeat the same policies they enacted in 1997-98. A recovery had begun in 1997, and the government decided to raise taxes. Immediately their economy fell back into recession and remains mired in the bog of zero growth.

The effect of Japan’s massive action to devalue the yen evokes a response from other countries of “Oh no you don’t!” Even Germany’s Bundesbank stated on March 13 that it supports the European Central Bank’s ability to buy loans and other assets to support the Eurozone economy, marking a radical shift from its prior hard-nosed conservative monetary policy. Germany is an export-driven economy, and the Germans are not about to let the price of a Mercedes become 25% to 50% more expensive than a Lexus in terms of US dollars.

To understand the effects of a currency war, one should look to the 1930s race to the bottom but replace the United Kingdom of 1931 with the Japan of 2013. On September 19, 1931, the UK abandoned the gold standard and started printing money. By December the UK pound sterling had fallen 30% versus the US dollar and set off a chain reaction of “me too” from France, Germany, Sweden, and Norway. There is obviously no gold standard to abandon today, and I realize things will be different in this war. However, all the central bankers are currently staring at each other across the table, hoping no one is going to blink and start implementing trade protection, capital controls, and specific import taxes in retaliation for money printing and currency devaluation. Sooner or later someone will blink. Each new round of government stimulus that results in less and less GDP growth eventually creates an “every central banker for himself” mentality

Short-term, Japan wins. Intermediate-term, the US wins as investors look for stability in what is called “the flight to safety” – and the dollar still has the advantage of being the world’s reserve currency. Long-term it will be China because of their central bank’s control of the yuan and their record for purchases of gold reserves.

All Hail The Fed! All Hail The Fed!

“Thus far, inflation has yet to raise its ugly head, and inflation expectations as measured by consumer surveys and market-traded instruments have remained stolid. However, with each passing day, constantly adding massive amounts to the monetary base will inevitably present a significant challenge to the FOMC, which must ultimately manage this high-power money so that it does not become fuel for sustained inflation above the committee’s 2 percent target once it is activated and flows into the economy.

“Thus, I was more than supportive of the collective decision of the FOMC to begin cutting back on our rate of accumulation of assets beginning in December. Over the course of our recent meetings, we have cut back from accumulating $85 billion per month in Treasuries and MBS to a present rate of $55 billion per month. This is still somewhat promiscuous. Even with the taper, the recent decline of mortgage supply has driven our absorption of the MBS market to 85 percent of fixed-rate MBS issuance. The fall in net MBS supply is outpacing the taper.

“At the current reduction in the run rate of accumulation, the exercise known as QE3 will terminate in October (when I project we will hold more than 40 percent of the MBS market and almost a fourth of outstanding Treasuries). We will then be back to managing monetary policy through the more traditional tool of the overnight lending rate that anchors the yield curve.”
Fed Vice Chairman Dr. Stanley Fisher, April 4, 2014

The investment world devotes tons of money and human resources to researching sales, GDP growth, corporate earnings, inflation, interest rates, commodity prices, etc., to ultimately decide whether we are in a bull or bear market. However, since March of 2009, there has been only one positively correlated predictor for the direction of stock prices, and that’s whether the Federal Reserve is easing or tightening. Simply look at the chart on the next page.

Will the Fed continue to taper if the market tanks? I predict the puke point for the markets will be when the taper lowers the monthly amount of asset purchases to the $20 billion mark. The Fed is currently purchasing assets and creating money at a rate of $55 billion per month. At the $20 billion mark tapering gets real; and as Dr. Fisher indicates, he anticipates QE3 to end sometime this fall. But will QE programs and Federal Reserve intervention ever truly end?

The markets have become addicted to their investment cocaine, and once the supply is cut off, then cold turkey withdrawal ensues. In my opinion, when the pain becomes too great and the powers that be start catching heat, then Dr. Yellen and Company will see their tapering plans torn up like a Walmart tent in a tornado. For now, they are still printing at a $55 billion-a-month clip, and with the release of last month’s meeting notes this week, it appears we still have a very dovish FOMC.

From an investment perspective, we will monitor the earnings and outlook of those companies we own. We will continue to run diversified portfolios that will always lag when stocks go parabolic, as they did in 2013. We have our eye on the euro, the yen, Ukraine, and other factors that could contribute to a crisis that the sell side and CNBC do not see coming. But most importantly, we will keep our focus on the Federal Reserve and the reactions of the markets to stated policy changes.

The Fed’s zero interest rate policy and suppression of interest rates causes investors to take risks they ordinarily wouldn’t take – be sure to understand your risk exposures. For example, note the 10-year and 30-year risk/reward of buying Treasury bonds:

Bonds appear to us to be today’s bubble investment. But there are
other treacherous investments out there – good luck.

Your thawed-out, losing-weight portfolio manager, Cliff

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk; and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Excelsia, Inc. is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.

Originally, on this day in 1922, the German Central Bank and the German Treasury took an inevitable step in a process which had begun with their previous effort to “jump start” a stagnant economy. Many months earlier they had decided that what was needed was easier money. Their initial efforts brought little response. So, using the governmental “more is better” theory they simply created more and more money.

But economic stagnation continued and so did the money growth. They kept making money more available. No reaction. Then, suddenly prices began to explode unbelievably (but, perversely, not business activity).

So, on this day government officials decided to bring figures in line with market realities. They devalued the mark. The new value would be 2 billion marks to a dollar. At the start of World War I the exchange rate had been a mere 4.2 marks to the dollar. In simple terms you needed 4.2 marks in order to get one dollar. Now it was 2 billion marks to get one dollar. And thirteen months from this date (late November 1923) you would need 4.2 trillion marks to get one dollar. In ten years the amount of money had increased a trillion fold.

Numbers like billions and trillions tend to numb the mind. They are too large to grasp in any “real” sense. Thirty years ago an older member of the NYSE (there were some then) gave me a graphic and memorable (at least for me) example. “Young man,” he said, “would you like a million dollars?” “I sure would, sir!”, I replied anxiously. “Then just put aside $500 every week for the next 40 years.” I have never forgotten that a million dollars is enough to pay you $500 per week for 40 years (and that’s without benefit of interest). To get a billion dollars you would have to set aside $500,000 dollars per week for 40 years. And a…..trillion that would require $500 million every week for 40 years. Even with these examples, the enormity is difficult to grasp.

Let’s take a different tack. To understand the incomprehensible scope of the German inflation maybe it’s best to start with something basic….like a loaf of bread. (To keep things simple we’ll substitute dollars and cents in place of marks and pfennigs. You’ll get the picture.) In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents. Two years later it was 19 cents. Two years more and it sold for 22 cents. By 1919 it was 26 cents. Now the fun begins.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50. At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went for $1200. By September it was $2 million. A month later it was $670 million (wide spread rioting broke out). The next month it hit $3 billion. By mid month it was $100 billion. Then it all collapsed.

Let’s go back to “marks”. In 1913, the total currency of Germany was a grand total of 6 billion marks. In November of 1923 that loaf of bread we just talked about cost 428 billion marks. A kilo of fresh butter cost 6000 billion marks (as you will note that kilo of butter cost 1000 times more than the entire money supply of the nation just 10 years earlier).

How Could This All Happen? – In 1913 Germany had a solid, prosperous, advanced culture and population. Like much of Europe it was a monarchy (under the Kaiser). Then, following the assassination of the Archduke Franz Ferdinand in Sarajevo in 1914, the world moved toward war. Each side was convinced the other would not dare go to war. So, in a global game of chicken they stumbled into the Great War.

The German General Staff thought the war would be short and sweet and that they could finance the costs with the post war reparations that they, as victors, would exact. The war was long. The flower of their manhood was killed or injured. They lost and, thus, it was they who had to pay reparations rather than receive them.

Things did not go badly instantly. Yes, the deficit soared but much of it was borne by foreign and domestic bond buyers. As had been noted by scholars…..“The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits.” In layman’s English that means foreign bond buyers said – “Hey this is a great nation and this is probably just a speed bump in the economy.” (Can you imagine such a thing happening again?)

When things began to disintegrate, no one dared to take away the punchbowl. They feared shutting off the monetary heroin would lead to riots, civil war, and, worst of all communism. So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.

Currencies, Culture And Chaos – If it is difficult to grasp the enormity of the numbers in this tale of hyper-inflation, it is far more difficult to grasp how it destroyed a culture, a nation and, almost, the world.

People’s savings were suddenly worthless. Pensions were meaningless. If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months. People demanded to be paid daily so they would not have their wages devalued by a few days passing. Ultimately, they demanded their pay twice daily just to cover changes in trolley fare. People heated their homes by burning money instead of coal. (It was more plentiful and cheaper to get.)

The middle class was destroyed. It was an age of renters, not of home ownership, so thousands became homeless.

But the cultural collapse may have had other more pernicious effects.

Some sociologists note that it was still an era of arranged marriages. Families scrimped and saved for years to build a dowry so that their daughter might marry well. Suddenly, the dowry was worthless – wiped out. And with it was gone all hope of marriage. Girls who had stayed prim and proper awaiting some future Prince Charming now had no hope at all. Social morality began to collapse. The roar of the roaring twenties began to rumble.

All hope and belief in systems, governmental or otherwise, collapsed. With its culture and its economy disintegrating, Germany saw a guy named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting. And then came World War II.

We think it’s best to close this review with a statement from a man whom many consider (probably incorrectly) the father of modern inflation with his endorsement of deficit spending. Here’s what John Maynard Keynes said on the topic:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.

To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.

Lenin was certainly right. There is no subtler, no surer means of over- turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.

]]>http://www.excelsia.com/2013/11/commentary-from-art-cashin/feed/0One Trick Pony: Whipping the GDP Donkey into a Stallionhttp://www.excelsia.com/2013/09/one-trick-pony-whipping-the-gdp-donkey-into-a-stallion/
http://www.excelsia.com/2013/09/one-trick-pony-whipping-the-gdp-donkey-into-a-stallion/#commentsThu, 26 Sep 2013 20:21:09 +0000http://www.excelsia.com/?p=1241“Sometimes the lights all shinin’ on me; Other times I can barely see. Lately it occurs to me what a long strange trip it’s been

“Truckin, I’m going home. Whoa, whoa baby, back where I belong, Back home, sit down and patch my bones, And get back truckin on”
– The Grateful Dead, “Truckin”

Psychedelic VW vans, tent villages, the Vietnam War, Jerry Garcia, “Deadheads”, protest marches, Watergate, termination of Bretton Woods and the gold-backed US dollar, oil embargoes, gas lines, inflation, and oh what a long strange money-printing trip our economy has been on since the ’70s. Forty-two years of relentless money creation in order to fund one governmental enterprise after another. However, the Federal Reserve’s money-printing expansion since the financial crisis of 2008 has been truly awe-inspiring, if not intimidating. The gargantuan size and scope of the Fed’s balance sheet expansion was unprecedented and unanticipated, and yet the reaction from the financial markets has been, “Give me more of that Keynesian cocaine!” The zero-interest-rate, subsidized prices of US stocks and bonds have created a wealth effect that masks potentially negative consequences to the vast majority of US consumers. For all their good intentions, I wonder whether the Federal Reserve can barely see or whether they have been blinded by the light. Surely they clearly see the erosion of purchasing power and declining real wages for most Americans over the last 25 years. And surely they see the limited effects on domestic economic growth in the US that have resulted from QE1, QE2, Operation Twist, and QE3. And while I will give Bernanke credit for fighting deflation and preventing a potential depression during the 2008–09 crisis, the end result of his continued money-printing policies is going to be inflationary pressure at some point. The trip the Fed took us on, from the first bailout of the banks in 1998 with Long Term Capital, was initially a prosperous if precarious one; but the bust of the credit cycle and inevitable deleveraging that occurred in 2008 financial crisis transformed the strange trip into a credit and banking nightmare that we have lived for the past five years.

We are in unknown and truly mind-bending territory with regard to the question of how much influence the central bankers of the world have on our global economy. This past week the Federal Reserve, after months of jawboning the marketplace with “Taper, taper, taper, taper,” coughed up the surprising decision not to change their current QE3 position of purchasing $85 billion per month of US mortgage-backed securities and other debt instruments. As I have commented over the last several years, Bernanke is a one-trick pony. His answer to every economic malady is to print money, and if that doesn’t work, then print more money. He is trying to create a 3% domestic GPD growth rate by lashing a donkey economy with a printing-press whip.

However, as I have stated in my last two letters, the problems with our domestic economy are structural, and the solutions for GDP growth and the reduction of unemployment reside in the hands of our President and Congress. Bernanke cannot substitute his incessant Keynesianism for much-needed tax reform, regulatory changes, and fiscal spending resolutions that would restore confidence in both large and small American businesses and promote investment and growth.

If you think the printing press is not out of control, then simply look at the following two graphs:

Since the beginning of the 2008 financial crisis, the Federal Reserve’s balance sheet has expanded from $800,000 to over $3.5 trillion, through June 30, 2013. As you can see from the graph above, most of the increase has been in two areas: (a) QE2 and QE3 purchases of mortgage-backed securities and (b) increased purchases of US Treasury notes and bonds. Warren Buffett recently called the Fed “the world’s largest hedge fund.”

The Federal Reserve, while it can create money, cannot create spending. However, by buying Treasuries the Fed creates money for Congress to spend, and by buying mortgages the Fed repairs bank reserves so that banks can get back to lending. Remember, lending (credit) creates spending, and without spending you have no GDP growth and no job creation. The Federal Reserve’s intent is for Congress to spend and bankers to lend, and thus we all follow the yellow brick road to a rejuvenated economy. The problem is, the wicked witch bankers are not lending, and the government spending is declining with mandated budget sequestering. The result of declining spending is that the velocity of money is now at a 50-year low!

The primary unintended consequence of Bernanke’s willingness to expand the Federal Reserve’s balance sheet is Congressional fiscal irresponsibility: why budget when you have a printing press?

One thing is certain regarding the Fed’s intervention in the financial markets with QE3: the investment world is acutely attuned to any action the Federal Reserve plans as it relates to the potential slowing down or speeding up of the printing press. One of Bernanke’s self-imposed mandates is to maintain asset prices, and frankly he has done a great job of propping up stock and bond prices with the combination of his Zero Interest Rate Policy and QE3. However, the price collapse in all asset classes during June at the mere threat of tapering is an indication of just how hypersensitive the investment world is to any indication of money-supply contraction. But recall Bernanke’s May 23rd speech, when he clearly said that any tapering would be conditional upon future economic indicators and that there was no certainty regarding whether or when the Fed would tighten.

Investors should be forewarned: if the markets will sell off on mere mention of a possibility, what could happen should taper policy become more than rhetoric? In my opinion, if the Keynesian cocaine line is ever exhausted, then the investment market’s rehab will look worse than Lindsay Lohan at Betty Ford.

But for now it is “risk on” for financial assets, as US economic growth and unemployment levels remain miles away from the Federal Reserve’s preconditions for tapering. Why did Bernanke not taper? In my opinion the Fed’s decision was shaped by four factors:

1. The data. Frankly, the data did not support the conditions needed for Bernanke to taper. August’s anemic employment report, combined with downward revisions of GDP (both actual and projected), would have required some serious explanation to justify tapering.

2. Janet Yellen versus Larry Summers. In my opinion this situation is getting ridiculous, and the President needs to go ahead and appoint a new Fed Chairman to replace Bernanke in January. The withdrawal of Larry Summers makes Janet Yellen the odds-on favorite; however, I would not rule out the possibility of Jeremy Stein, given his relationship with the President. Yellen is not yet a shoe-in.

3. Congressional ineptness. We have a problem in our country. In a time when we need reforms and changes, nothing is going to happen on Capitol Hill. The polarization is too great, and the grandstanding, name-calling, and spin-mastering of events is defeating us from within. Bernanke correctly recognized that the announced initiation of tapering combined with a showdown on Capitol Hill over the debt ceiling would have been too much for the markets to handle. Therefore, in the name of price manipulation – excuse me, stability – he elected not to taper.

4. Unemployment. The chart below says it all.

Now What?

The investment community is totally confused about the supposed “transparency” of the Fed, given their decision not to taper at the September meeting. Although I am sure it was not orchestrated, on the day following the FOMC committee’s announcement, St. Louis Fed President James Bullard indicated the Fed might well begin tapering at the next meeting, in October. The markets responded to Bullard’s comments by totally wiping out the gains of the prior day’s trading. The Fed is beginning to look like a puppet master that has every investment firm in the world dangling from strings. The Fed has got everyone packed into Hotel California, where guests can check in but never leave. Or is it Roach Motel, given the Fed’s tremendous expansion of its balance sheet? I fear that reducing the $3.5 trillion on the balance sheet will prove much more difficult than increasing it – so much so that I doubt the Fed can reduce it anytime soon. Bottom line: the Fed is stalling for time. Bernanke & Company are hoping that the economy will improve and the markets will eventually ease off the crisis-management mode they find themselves in today. Or, at a minimum, that the crisis mode will at least ease long enough for Helicopter Ben to fly off to his Princeton Keynesian retreat.

All Quiet on the Eastern Front

“Nobody in Europe will be abandoned. Nobody in Europe will be excluded. Europe only succeeds if we work together.”
– German Chancellor Angela Merkel

On September 24, 2013, the German people re-elected Angela Merkel to extend her eight-year reign as chancellor for at least another two years. However, the outcome is somewhat bittersweet, with Merkel’s former coalition partner, the liberal Free Democrats (FDP Party), suffering a stinging rebuke in Bavaria. The upshot is that Merkel, in order to rule by majority, will have to find a way to work with the Social Democrats (SPD Party). The question is whether the Social Democratic leadership will go along with patriotic support of Merkel, or let the left-wingers in to push for an alternative government. All of which makes me wonder whether Chancellor Merkel really has the support she needs to push the Bundesbank into some form of euro unification.

Sabine Lautenschlager, who is in charge of banking supervision for the Bundesbank board, said last week that the EU treaty and ECB statues lack a mechanism to unify the euro. “For a permanent and consistent solution an appropriate foundation in the primary law is needed,” she stated. In other words, Lautenschlager is calling for some form of central bank. My expectation is that, once internal politics are aligned, Germany is going to begin playing a game of hardball with the French, Italians, Spanish, Greeks, and Portugese for control of the euro. Like it or not, the Bank of Japan has launched a currency war that Europe will be forced to respond to. They cannot do so when a unified vote of 17 countries is needed to shift Eurozone currency policy. I still view the euro as the biggest risk factor affecting the stability of global financial markets.

Mean Reversion and Asset Allocation

What a strange year. Through August 31, 2013, returns by asset class:

S&P 500 Index +16.1%

Emerging Markets Equity -10.1%

US Bonds -2.8%

Global Bonds -4.2%

Emerging Market Bonds -9.0%

Commodities -6.2%

Gold -17.9%

“This is the hardest time to be an asset allocator.… Normally, you find that safe-haven assets are expensive and riskier assets are cheap – and vice versa. But today, largely because of the central banks around the world, we’ve got a very distorted opportunity set, such that there is nothing you can buy and hold.”
– James Montier, GMO

Excelsia’s investment process involves a valuation method that is based on mean reversion. Mean reversion is a mathematical concept that identifies trade ranges for an asset class, where deviations in prices are expected to revert back to a longer-term average. I have often used baseball statistics as an example of mean reversion. If a hitter averages .300 during his career, there are times when he hits .150 (aka “a slump”), and there are times when he hits .450 (aka “a hot streak”). In terms of investing, we want to be buying the player’s contract when he hits .150 and selling his contract when he hits .450. In finance, Jeremy Siegel of Wharton fame and author of Stocks for the Long Run uses mean reversion to describe a time series in which returns can be very unstable in the short run but very stable in the long run

We measure short-term volatility in terms of “standard deviations,” which indicate how far a current asset price has deviated from its longer-term average price. In our investment process we look at metrics such as earnings, sales, and profit margins to determine how these valuation measures will impact prices, to see whether an asset class is likely to revert to its historical average over a three-year time horizon and whether that mean reversion will result in higher or lower prices versus where the asset class is priced today.

The difficulty since 2012 has been that if you are not significantly overweight US equities, then your returns are less than stellar. Employing a diversified, risk-averse investment strategy in 2013 has in hindsight been the wrong thing to do, given that every other asset class is negative year-to-date, while US stocks are up double digits. The combination of the Fed’s Zero Interest Rate Policy and the artificial bubble in Treasury bonds has forced conservative investors into riskier positions in order to find risk-adjusted returns. One investment area that we have become more attuned to over the last two years is the “alternative” space. The investment opportunities in long/short funds, event-driven funds, mezzanine debt funds, and commodity futures have historically been the domain of large institutions or ultra-high-net-worth individuals. However, the landscape is changing, with a number of hedge fund strategies now becoming available in mutual funds and ETFs. To mitigate risk and replace bond exposure and yield, the alternative mutual funds are becoming more and more attractive. Why?

Think about it: just five years ago the risk-free rate (as defined by a 90-day T-Bill) was 4%. To achieve a 6-8% return you had to earn 1.5 to 2 times the risk-free rate. Today the risk-free rate is 0.15%, and so to achieve a 6-8% return you have to earn 40 to 53 times the risk-free rate, which is an enormous task if, at the same time, you seek capital preservation. And in today’s market you have to do this in the face of Congressional debates on the budget and debt ceilings, potential Federal Reserve tapering, concerns about what the German election means to the euro, Japan’s initiation of a global currency war via the most massive monetary expansion ever, a potentially massive Chinese contraction, atrocities in Syria and other parts of the Middle East, and how the world will respond to them. Meanwhile, we’re experiencing peak corporate earnings, a bull market that is 53 months long, and a potential end to the 30-year bull market in bonds due to currently rising interest rates. Other than that, Mrs. Lincoln, how are you liking the play thus far?

Words of Wisdom

I leave you with two recent videos posted on YouTube. The first is Warren Buffet’s conversation with Bill Moynihan, CEO of Bank of America, at Georgetown University on September 19th, in which Buffett calls the Federal Reserve “the world’s greatest hedge fund in history.”

The next is a release by Ray Dalio on “How the Economic Machine Works.” Ray is the founder of the investment firm Bridgewater Associates, which manages $125 billion. This Econ 101 course is well worth the 30 minutes.

Good luck out there.

Cliff

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Excelsia, Inc. is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.

You ever watch Night of the Living Dead,I Am Legend, or any of the other fictional accounts of the breakdown of civilization? Personally, I never watch horror movies or anything that has evil at its core. The last scary movie I watched was The Fly when I was 7 years old. It gave me nightmares for weeks on end, and I swore off horror films. However, I have lately been exposed to zombies, thanks to my youngest son (now 17), who can drive me nuts with his Xbox killing of zombies for endless hours while his English paper due tomorrow must wait.

Our undead-obsessed culture has embraced zombification in a big way, with action games (Resident Evil, House of the Dead), novels (The Zombie Survival Guide), television (The Walking Dead), action movies (World War Z), and the newest phenomenon, Zombie Walks. In October 2010, 4,000 undead creatures participated in the New Jersey Zombie Walk, lurching mindlessly through the streets. You might think of a Zombie Walk as a Flash Mob in slow motion. Zombies (in case you haven’t been exposed) are corpses raised from the dead who relish human flesh. Their dietary preference eventually leads to Zombie Apocalypse, whereby the ruling elite of the world – the (savory) fat cats – are all consumed, and the world is completely taken over by the undead (who then presumably go hungry).

The enthusiasm of our culture for Zombies is estimated to contribute a tidy $5 billion dollar a year to GDP, and that doesn’t even include the too-big-to-die zombie banks. In my opinion, the acute interest in zombies and horror (and escapism in general) says something about our country’s mental health.

It may say something about our economic health as well. In a world where 99% feel disempowered, the average American’s financial net worth has declined nearly 40% in the wake of the economic crisis of 2008-09; real wages have been declining for 30 years; and our government is now breaking a generational promise to the Baby Boomers, the Gen X’s, and the Gen Y’s with regard to retirement and health care. So is it any wonder that playing dead or watching a movie in which the 1% is served up for lunch is entertaining to the vast majority of Americans, who can’t get ahead?

And now our investment markets, too, are starting to zombify, as the number of believers flocking to the Bernanke Church of QE to Infinity swells and we experience a disconnect between unreal stock market performance and the underlying numbers that tell of anemic GDP growth, continued high unemployment, ongoing troubles in the Eurozone, and the onset of the Bank of Japan’s most reckless monetary experiment ever.

Grant Williams, author of the inimitable newsletter Things That Make You Go Hmmm…, made a presentation called “Do the Math” to the CFA conference in Singapore on May 21, 2013. His presentation can be seen by clicking here, and it is worth 48 minutes of your time to watch. Grant’s proposition is that QE policies on a global scale have created an artificial environment of inflated stock prices, particularly in the US, which is viewed as the safest of markets. As in the game of musical chairs, all investors playing the QE momentum game think they are smart enough to anticipate Bernanke & Company’s actions regarding tapering of QE and to hurriedly exit stage left before the decline in stock prices sets in. Really? Let me remind you of the confidence everyone had in 2007 regarding real estate:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We are still dancing.”
– Chuck Prince, former CEO of Citi Group, describing the bank’s mortgage lending and CDO practices in July of 2007. Oooooh, I feel David Bowie’s “Let’s Dance” start humming in my head as I watch investors do the Global QE Shuffle.

Ride ‘Em Cowboy

Central bank practices and continued QE stimulus have disconnected equity asset prices from their historical perspectives and valuations. Ever since the establishment of bailouts and QE policies, the equity markets have responded positively to the Keynesian cocaine stimuli of the Fed, Bank of England, Bank of Japan, and ECB, with a jolt upward of more than 100%, as shown in the following graph.

At the beginning of each quarter, we develop a series of forecasted returns. After the number crunching that is our discipline, Troy and I always look at each other and ask, “Are you ready to bet against a man who owns a money-printing press in his basement?” Given an 89% positive correlation to rising stock prices when the Fed is printing, we always answer “No.”

First Non-QE Period – March 31, 2010, to August 27, 2010 (down -8.97%)

QE 2 – August 27, 2010, to June 30, 2011 (up 22.81%)

Second Non-QE Period – June 30, 2011, to August 26, 2011 (down -9.99%)

Operation Twist – August 26, 2011, to April 4, 2012 (up 18.88%)

Hilsenrath Says QE to End with Twist’s End – April 4, 2012, to June 6, 2012 (down -5.99%)

Hilsenrath Backtracks on QE’s End – June 6, 2012, to August 17, 2012 (up 7.83%)

As asset managers we understand the artificial nature of current market prices and the fickleness of traders as the Fed debates whether and when to taper. Since Bernanke’s speech on May 22nd introduced the possibility that the Fed could decide to reduce QE over the next two FOMC meetings, the Dow Jones Industrial Average has experienced 100-point swings in 7 of the last 10 trading sessions. From Bob Pisani’s Twitter feed for June 12th: “Volatility is up since Bernanke’s May 22 testimony. DOW’s average daily trading range from Jan. 2 – May 21: 109 points; since May 22: 184 points.”

I borrow the following from Chris Low at FTN Financial:

There are three problems with tapering:

Bernanke does not like “tapering” because tapering implies reduction only. The Fed is still considering changes to the program which could involve decreasing or increasing the size of purchases, or a change in the mix of mortgages and Treasuries. The Fed also reserves the right to reverse course midstream. In other words, they continue to insist they might upsize QE.

Also, tapering implies a steady progression, with reductions in purchases in even increments until it is finished. The Fed believes predictable schedules are disruptive. Bernanke has repeatedly said the Fed wants to move away from predictable schedules of policy changes to avoid this disruption.

The Fed may change its plans if it thinks the market has gotten ahead of itself and the Fed WILL change its plans if economic conditions support a change. That might mean inflation remaining as low as it is now, especially if inflation expectations drop further. Or, it might mean a change in policy if home sales show or employment stall.

The Fed has assumed a dual mandate of reducing unemployment and stimulating GDP growth that is, in our opinion, impossible. Why impossible? The problems that exist in our economy are structural and cannot be solved by the continued printing of money. From our friend Dr. Jason Hsu at Research Affiliates:

The ability to print money gives the government an ex post option to renegotiate (write down) its debt in real terms. If the government spending and/or investments prove wasteful or unwise, it can allocate the pain to bondholders by printing more money instead of facing the wrath of the electorate by raising taxes in a slumping economy. This option to renegotiate debt without legislative procedure enables irresponsible spending by the government, perpetually, or at least until rampant inflation ensues…. The government’s willingness to borrow rather than tax is a statement about its ability to allocate pain. Higher taxation today allocates pain to wage earners now. Borrowing is a tax on future wage earners.

The continued monetization of debt by the printing of more and more money allows our leaders (if there are any) in Washington, DC, to postpone legislation that would promote growth in our country. We have a fiscal problem of deficit spending, with a President and Congress who refuse to address the issues related to reducing government outlays. Their recalcitrance has been aided and abetted by the Federal Reserve’s willingness to simply keep printing more money.

Structural issues that need to be addressed before our economy will grow again are fourfold:

meaningful tax reform, both corporate and individual

immigration reform to create a broader and more robust demographic that will contribute both to the labor pool and to domestic consumption

reform of the regulatory environment that is choking businesses’ willingness to invest in capital projects (We must admit that Dodd-Frank did nothing to correct the problem of too-big-to-die zombie banks, and we must revise its complicated provisions and regain the ability to write the rules as we go.)

repeal of Obamacare, which will otherwise unleash a landslide of destructive unintended consequences.

If you think Obamacare is not affecting employment, then consider the following. Employers with more than 50 full-time employees will be subject to the employer mandate in the Affordable Care Act, whereby they will either pay for health insurance for their employees or pay a fine beginning in 2014. Rather than opting to grow by hiring, small businesses are seeking ways to reduce their full-time employee count, and thus we now have the term job splitting. Although unemployment is declining due to the hiring of more part-time workers, wages are declining in the aggregate. The reduction of wages translates to weaker consumption.

This is but one example of a structural problem that cannot be cured by Federal Reserve monetary policy. Consider one of our clients, who employs over 300 full-time workers and currently provides them with what Obamacare terms a “Cadillac insurance plan,” which will be penalized under the Affordable Care Act. Rather than continue their plan, the company will terminate health insurance for its employees at the end of this year and simply pay the per-person Affordable Care Act penalty.

I see nothing in the Affordable Care Act that addresses the runaway government spending associated with Medicare and Medicaid. However, these structural issues can be fixed. Our country still has choices – we are not yet in Europe’s or Japan’s shoes – but the solutions will require federal government leadership. And this is the real problem our economy has: in a time when we critically need leadership, we have a President and Congress content to do nothing as long as the Fed keeps the stock market moving up. NY Times columnist Maureen Dowd, in her column dated April 21, 2013, sizes up this failure of leadership:

President Obama has watched the blood-dimmed tide drowning the ceremony of innocence, as Yeats wrote, and he has learned how to emotionally connect with Americans in searing moments, as he did from the White House late Friday night after the second bombing suspect was apprehended in Boston.

Unfortunately, he still has not learned how to govern.

How is it that the president won the argument on gun safety with the public and lost the vote in the Senate? It’s because he doesn’t know how to work the system. And it’s clear now that he doesn’t want to learn, or to even hire some clever people who can tell him how to do it or do it for him.

It’s unbelievable that with 90 percent of Americans on his side, he could get only 54 votes in the Senate. It was a glaring example of his weakness in using leverage to get what he wants.(my underlining)

This editorial is from one of the more liberal supporters of President Obama! The message here is that there will be zero structural changes until 2015 or later, depending on election results in 2014. Without structural reform, the only game in town is to buy time and prevent short-term catastrophe, which is the main purpose of the Ben Bernanke printing press. And remember, political time is very different from market time. Politicians know what the problems are, and they know the solutions; they just can’t figure out how to get re-elected when they do the right thing.

A democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising them the most benefits from the public treasury, with the result that a democracy always collapses over a loss of fiscal responsibility, always followed by a dictatorship. The average of the world’s great civilizations before they decline has been 200 years. These nations have progressed in this sequence: From bondage to spiritual faith; from spiritual faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage.
– commonly but not verifiably attributed to Alexander Tytler, 1776

Therefore our conclusion is that Bernanke & Company will not begin tapering anytime soon, as nothing has changed with regard to unemployment or GDP growth or our legislative process in the last five months. Congress and the President will do nothing, in part because the Fed facilitates the fiscal irresponsibility. We see a continuation of anemic growth at the 1-2% level without any significant gain in employment. Furthermore, we opine that Helicopter Ben will ride the printing press until he retires as Fed chairman in January of 2014 – effectively kicking the can and handing off the issues of inflated monetary stimulus to the next Fed chairman. The end result of the glut of fiat currencies dumped on the world by the global central bank fraternity will be inflation; and it’s not a question of if, but when. As my friend John Mauldin says, the US will come to its own Bang! moment of the End Game, but at a later date, and after Japan does.

In my commentary this past March, I presented the case that Europe was our biggest risk factor for investing in 2013. Although I still think there are large European risk factors, I don’t want to underestimate the market earthquakes Prime Minister Abe is setting off in Japan. In January, the Japanese adopted Abe’s plan for huge monetary easing and government spending as the fuel with which to attain escape velocity from 20 years of zero growth and errant government policies. The sheer size of the monetary stimulus is astounding: three times the monetization efforts of our Federal Reserve, in relative terms. When Abe’s program was launched in November 2012, the Japanese markets responded with an 80% appreciation in six months and a 4.1% growth rate for the first quarter of 2013. But now the doubts are creeping in as to whether doubling Japan’s debt level in an effort to significantly devalue the yen versus other currencies will pay off – or backfire in a big way.

As John Mauldin and Kyle Bass have so adeptly reasoned, Japan is a bug destined for a windshield. The country has an aging population and almost no net immigration, natural resources supply-chain issues, twenty-plus years of zero growth coupled with misguided government spending that has resulted in a debt-to-GDP level of 285% (the US is at 90%), and a government that must now resort to desperate measures to try to restore growth and fiscal balance.

Japan has an export economy, and the only way for it to grow is to take market share from Germany, China, Korea, Taiwan, and other countries. Abe’s goal, in my opinion, is to gain market share, not through innovation and superior products, but the old-fashioned way: by means of a currency war. Let’s make the price of a Lexus in the US the same as the price of a Hyundai, he reasons. But does Japan really think the Germans, Chinese, and Koreans will sit idly by and allow the unilateral devaluation of the yen?

And bear in mind, this is the first time a currency war would occur in which all the currencies involved are fiat currencies – no one has any hard-asset-backed money: it’s all paper.

Abe’s second objective is to create inflation of 3% in Japan, as he desperately needs to inflate away the massive amounts of government debt. Where will his policies finally take him? No one knows, including him: we have never been here before, and anyone who attempts to depict precisely how and when the End Game will play out is simply guessing. However, at Excelsia we have made a strategic decision to maintain gold and hard-asset mining companies as a part of our portfolio. We are probably early, and we all know what early means in the investment business: you’re wrong in the short term. But the massive amounts of new money the fraternity of central bankers is pumping into the global financial system will have consequences, intended and unintended. Our best guess is that one of the consequences will be inflation – perhaps not the hyperinflation we have written about in the past, but inflation nonetheless.

Gold and Gold Stocks

Contrarian: a person who takes a contrary position or attitude; specifically an investor who buys shares of stock when most others are selling and sells when others are buying. (Merriam-Webster Online)

Between April 12 and April 15 of 2013, gold declined 14.9% in two days. In terms of statistical probability, this represented a 3-standard-deviation move from its mean average. Bloomberg News reported on April 16th that rather than panic, the world’s most avid consumers of gold, the citizens of India, flocked to the jewelry and coins shops in a buying frenzy. As we evaluated the carnage and looked at mining stocks down over 40% since November and the price of gold down 20%, we were reminded of health-care stocks in 2010. Recall that the passage of Obamacare that year resulted in Johnson & Johnson, Merck, Pfizer, Eli Lilly, and other health-care stocks sinking to new lows in July, 2010. Nationalized health care was here; government price controls were going to make big pharma unprofitable; and all of health care was shunned. During that year we began to buy those companies for one reason: value! They paid 4-5% dividends, were still growing (if not by double digits), and their balance sheets were strong. When gold stocks sold off at an unprecedented pace, we had the same thought again: value! The chart below depicts what we think of as value:

2013 EPS Est.

2014 EPS Est.

2013 P/E

2014 P/E

Indicated Dividend

Yield

2013 Payout Ratio

BHP

4.31

5.19

14.6

12.1

2.28

3.63

53%

RIO

5.63

6.16

7.7

7.0

1.83

4.23

33%

FCX

3.43

4.01

8.6

7.4

1.25

4.23

36%

NEM

2.68

3.33

12.4

9.9

1.40

4.23

52%

ABX

3.07

3.24

6.4

6.0

0.80

4.10

26%

Source: S&P

How Do You Invest?

US Trust conducted a survey at the beginning of this year, questioning how the wealthiest 1% in this country, who own 40% of an estimated $54 trillion of the nation’s total wealth, were investing in today’s market. Everyone in the survey was worth a minimum of $3 million, and one third of the respondents had $10 million or more. The survey showed that:

… 88 percent of respondents feel financially secure today and 70 percent feel confident about their financial security in the future.… However – and this is where the dual personality comes in – the wealthy are still holding mountains of cash. The survey found that 56 percent have a “substantial” amount of cash. Only 16 percent of them plan to invest that cash in the next couple of months. And only 40 percent plan to invest it over the next two years.

In my opinion, most individual investors have not participated in the market appreciation that has occurred since March, 2009. The market has been driven by institutions, high-frequency traders, and hedge funds. Most individual investors lack investment discipline and are led more by their emotions than by careful analysis.

Unbelievable

From the Wall Street Journal of May 24, 2013:

All trades in American Electric Power Inc (AEP.N) and NextEra Energy Inc (NEE.N) in a crash that happened in the first minute of trading on Thursday will stand, the New York Stock Exchange said, following the latest in a flurry of unexplained sharp drops in the market.

The stocks each dropped more than 50 percent in the first minute of trading, though they ended just down slightly. Individual stock moves of 10 percent or more in a five-minute period usually trigger a trading halt, based on SEC rules, but the rules do not apply to the first 15 minutes of trading or the last 30 minutes of a session. The exchanges are able to cancel trades in the event of irregular or erroneous activity.(my underlining)

On May 6, 2010, the stock market experienced what has come to be know as a “flash crash,” in which the Dow plunged 1,010 points, only to recover in a matter of minutes. To date, no one knows what happened. On Thursday, May 23, the market experienced a similar occurrence that involved two utility stocks, AEP and NEE. The key diffference between the two events proved to be a stunner: the exchange nullified trades that occurred in the flash crash but let stand the trades of AEP and NEE. What this means is that an investor who had a stop loss and sold his shares in the opening at $20, only to have the stock recover to $42, was abused. And the NYSE honored the trades as good trades. Unbelievable! Do you think the high-frequency traders are smart enough to exploit such a market? Furthermore, the NYSE said they will be marked with an “aberrant report indicator”. While those trades are still valid, NYSE said they “will be excluded from the high and low data” disseminated by the Consolidated Tape Association, which oversees the dissemination of real-time trade and quote information in NYSE-listed securities. FactSet data shows that hundreds of trades in both stocks were priced below those prices (the LOW of the day).

So the bottom line is the plunge in these shares were wiped off the tape, but NOT from investors’ portfolios. In fact, if you pull up an historical chart on both tickers, it never happened!A solution to prevent this kind of abuse is for the exchanges and the SEC to restore the “uptick rule.”

And you thought utility stocks were for grandmas, widows, and orphans.

Good Luck Out There!

Cliff

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Excelsia, Inc. is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.

Please pardon the tardiness of this Q1 commentary about the whacked-out, overpoliticized, central-banker-meddling investment environment we currently live in. January and February were a challenge for our rebalancing process as the equity markets celebrated their best January since 1994, and our focus on repositioning the portfolios required that we redouble our normal diligent attentiveness to the markets.

I predict the Ides of March will find us in a continued sequestration, and Congress will use the time between now and the debt ceiling deadline on March 27th to debate the merits of true tax reform as opposed to governing by crisis. In the end, though, the reform conversation will revert to governance by crisis, with another stop-gap measure to avoid government shutdown during Holy Week and Easter, which will tide us over to the elections of 2014. Do you expect any different?

Let’s look at what we have learned from the 2012 election: 21 of 22 incumbent senators were re-elected, as were 353 of 373 incumbent members of the House. The American people thus re-elected 94 percent of the incumbents to an institution that has an approval rating of about 9 percent. In other words, nothing has changed. This indicates that, as an electorate in desperate need of leadership and change, we are a nation of idiots. We’re now stuck with the useless, dysfunctional government that we deserve. The only good news is that the investment markets seem to be blithely ignoring the US government’s ineptness, and the Dow averages are surpassing their 2007 all-time highs as I write.

I have remarked in prior first-quarter newsletters that the passing of the New Year is about the only time of year when most people reflect on the past, ponder the present, and plan for or try to predict the future. The New Year always brings with it the crystal-ball question, “Cliff, where do you see the markets over the next year?” Like most market pundits I am tempted to answer with absolute numbers, but experience has taught me that these types of predictions tend to prove me far smarter or dumber than I deserve. There are, however, several themes we have identified that will affect our asset-allocation discipline for 2013. As I commented in November, the market risks are geopolitical and the sentiment is driven by government policies. Our themes for 2013:

The Slowest Train Wreck: Europe

Buzz Lightyear International Monetary Policy

Energy Is the Answer

Main Street versus Wall Street

The Slowest Train Wreck: Europe

In 2011, Jean-Claude Juncker, the prime minister of Luxembourg, denied attending a meeting about the restructuring of Greek debt. When that falsehood was exposed, Juncker responded, “When things get serious, you just have to lie.”

Which pretty well sums up the consensus of elected officials in dealing with the massive deleveraging and insolvent banks of the EU. The eurozone –an amalgamation of 17 countries, 100 political parties, and 20 different languages – is hobbling along without fiscal union, political union, or banking union created by a central bank charter. The force that holds the euro together is Germany, which, since the creation of the euro and the institution of trade agreements to open borders, has enriched itself, with the unintended consequence of impoverishing its southern EU neighbors. Germany now has to make the unenviable decision whether to support the euro and with it Mario Draghi and the European Central Bank, or to play the world’s biggest game of chicken in the global currency markets. I do not see a clear direction emerging from Germany regarding euro support until after the German elections in the fall. Therefore, in the near term, I expect a continued kicking of the well-dented monetary can down the road, through a combination of the ECB’s ability to purchase Greek, Italian, and Spanish bank debt and plenty of rah-rah rhetoric from Draghi.

Eventually, however, Germany will no longer be willing, in order to back up the euro, to prop up banks that would otherwise fail in Greece, Spain, and Italy. While the euro will not disappear, there will be fierce resistance from France, Italy, et al. to a central bank charter with Germany in control. And yes, Germany will either assert control or opt out of the discussion regarding a central bank charter and establishment of the equivalent of a US Federal Reserve as part of the ECB.

Evidence of Germany’s intent to take control of the ECB is seen in their announcement on January 16th that they would repatriate their physical gold from US and French bank vaults. The Bundesbank indicated its intent to withdraw 674 tonnes from US vaults over a seven-year period; however the 374 tonnes in France is to be transferred as soon as possible. Taking back their gold from the French is a sign that Germany is going to stop playing Mr. Nice Guy to France and is prepared to assert more leverage over the future of the Euro. Germany is fighting for control of the ECB against a group of mostly southern states, led by France; and the outcome will impact debt markets, unemployment, and social stability. Holding Germany’s gold in the US, England, and France post-WWII was a quasi-insurance policy that Germany would not start another war. However, since the Germans have already conquered all of Europe economically, the war now will be for control of the shared currency, banks, and trade.

Two scary charts:

When you get massive unemployment of the type being experienced in Greece and Spain, particularly among those 25 and younger, combined with severe austerity measures imposed by the “German Oppression,” then the time is ripe for revolution, or at least for the restructuring of entire government systems. The problems in Spain and Greece have not gone away. And, the recent election results in Italy point towards Southern Europe’s unwillingness to remain under the German boot. But make no mistake, for the Germans to continue supporting the ECB, they will demand further austerities from Spain, Greece, and Italy.

Although Mario Draghi has been successful in restoring confidence in the euro by resorting to the same bazooka tactics as his Keynesian Kousin Bernanke, the ECB’s charter still lacks the basic tenets of a central bank. Germany, known for its silver bullet trains and on-time efficiency, is about to engineer the slowest economic train wreck the world has ever seen.

The following link is to GMO’s James Montier and his commentary on “Hyperinflations, Hysteria and False Memories”:

I encourage you to read his analysis, but I will attempt to summarize Mr. Montier’s plausible case that hyperinflations are not simply the result of central banks printing money to finance government debts. According to his thesis, three other conditions need to accompany the printing of money:

1. A large supply shock – the most common event that causes this is war. There needs to be a significant interruption of a country’s ability to produce goods and services. The scarcity of goods leads to rapidly rising prices, which leads to printing even more money.

2. Large debts denominated in foreign currencies – leads to currency devaluation. In the case of the US, we would have to owe debts issued in yen, euros, or yuan that would be payable only in the foreign currency, not in US dollars. In Europe, they would owe debts in US dollars or yen, for example. When your currency is falling versus other currencies, you print more money.

On the basis of these preconditions, I would argue that those forecasting hyperinflation in nations such as the US, the UK, or Japan are suffering from hyperinflation hysteria. If one were to worry about hyperinflation anywhere, I believe it would have to be with respect to the break-up of the eurozone. Such an event could create the preconditions for hyperinflation (an outcome often ignored by those discussing the costs of a break-up). Indeed, the past warns of this potential outcome: the collapse of the Austro-Hungarian Empire, Yugoslavia, and the Soviet Union all led to the emergence of hyperinflation!

Again, I recommend taking time to read Mr. Montier’s commentary; his history lesson of the various hyperinflations is enlightening. The potential breakup of the euro is, in my opinion, the most serious economic risk on the horizon.

Buzz Lightyear International Monetary Policy

My sons are now 21 and 17 years of age, and so it has been some time since I had to sit through a lot of animated movies. However, memories linger. The first feature-length computer-animated film, released in 1995, was Toy Story, featuring Woody and Buzz Lightyear. “To Infinity and Beyond!” was yelled in my home for weeks on end, to the point where the movie was almost banned from our VCR.

Now, Japan, the United Kingdom, the eurozone, and the US seem to have adopted a monetary policy that embodies Buzz Lightyear’s mantra. Or perhaps they are taking up Captain James T. Kirk’s promise to “boldly go where no man has gone before.” Either motto is a perfect fit as our intrepid global leaders set out for the Keynesian frontier they are so eager to explore. Why have the US, Europe, and now Japan so enthusiastically embraced John Maynard Keynes’ recommendations for government intervention, while ignoring Ludwig von Mises’ Austrian model, Irving Fisher’s work on debt deflation, and even the more recent challenge by Milton Freidman to naïve Keynesian economic policies that promote the government’s role in free markets? Since we can’t answer that one, perhaps we’d better just ask, how do we manage our investments in a market environment so dependent on Keynesian monetary stimuli, where predictions of future macroeconomic and geopolitical behavior are nigh on to impossible?

Although we have been assured by Mr. Bernanke in his latest testimony before Congress that the Fed has its thumb securely in the dike of inflation and stands willing to transform QE should inflation start slopping over the top, he also countered that statement by saying that the risks of killing the recovery far outweigh the risks of inflation. Keep in mind that this is the same individual who in 2006 commented that the prices of houses simply reflected the overall strength of the economy and had nothing at all to do with a financially engineered bubble in housing or with abuses such as NINJA loans granted with government guarantees from Fannie and Freddie – no income, no job, no assets, but your government would like to give you a 100%, no-equity loan for a house you cannot afford.

The Fed’s current behavior can be viewed as a symptom of continued problems in the banking system, particularly with regard to housing and real estate. Bubbles when they burst don’t repair themselves quickly. As Mr. Bernanke reiterated in this past week’s Congressional testimony, the Fed can do little to stimulate the economy, but it can create inflation and reassure the investing world that the Bernanke Put is still good.

Nevertheless, it seems to me the Fed’s top priority in the months ahead will not be inflation or jobs but rather continuing to prop up the banking system and to provide back-up liquidity to the US Treasury. In the long term, direct monetization of Treasury debt will tend to weaken the US dollar, boost oil and gasoline prices, boost money supply growth, and spur domestic inflation. In the short term, the dollar is still the cleanest dirty shirt in the currency closet and is appreciating, while stocks will act as inflation hedges, bonds will continue to return paltry yields relative to their risk, and government entities will continue to kick the can of fiscal responsibility down the road as long as the central bankers are willing to bail them out.

For now, you cannot fight the Fed, the Central Bank of Japan, and the ECB with their ongoing parade of cheap money. The excess liquidity being pumped into the investment world will have to go somewhere, and it will pour primarily into stocks and bonds, as investors and bankers around the world remain reluctant to buy or loan money on illiquid assets. The world is all too aware that any sudden shift in monetary policy could cause a reaction in the markets overnight, and so adequate liquidity is required.

The unintended consequence of the market’s Keynesian high is another “Minsky moment” is in the making; I just cannot tell you when or where. Paul McCulley of PIMCO coined the phrase to describe the 1998 Russian financial crisis. A Minsky moment comes after a long period of financial prosperity and increasing value of financial assets lead to speculation and investors willing to use borrowed money. At some point the markets reverse, and indebted investors are forced to sell assets to pay back loans. The concept ties into von Mises “Austrian School,” which theorized that the prolonged use of low interest rates by central bankers leads to excessive credit expansion and economic bubbles. The longer the markets remain complacent about low rates and the willingness to use leverage, the bigger the bubble grows and the louder the pop when it bursts. When that moment will arrive this time around is anyone’s guess; but for now, don’t fight the Fed.

Energy Is the Answer

The USA is a blessed country. Despite our political issues, debt issues, future entitlement liabilities, and seemingly unsustainable healthcare system, our country is blessed with three assets that are unmatched by those of any other single country in the world: energy, water, and food. The US economy enjoys a distinct advantage over the next two largest economies, China and Japan, and that is that we do not have to worry about our supply chain for food, water, and energy. We have competitive advantages that China tries to offset with cheap labor and Japan through a cheaper currency. However, energy and food are keys.

The recent boom in US natural gas production has driven the price down from $11 per million BTU two years ago to under $3 in 2012. The chart below is a sampling of the costs of natural gas around the world in July of 2012, by the Federal Energy Regulatory Commission. The thing that leaps out from this chart is the low cost of US gas versus the cost in the rest of the world. Because of the US boom in natural gas supply, there is an opportunity for public/private partnership between the US government and the gas producers, which would be a win-win for everyone in the game of exporting. Obama could, with thoughtful export policies and taxation of the export facilities, potentially pay for future entitlement and healthcare spending for the next twenty to thirty years. Such a program will require compromise, and with the recent appointment Ernest Moniz as Energy Secretary, we may see initiatives in 2013 to convert LNG import facilities to export facilities. On January 13, 2013 a bipartisan group of US Senators introduced legislation to amend Section 3(c) of the Natural Gas Act in order to expedite Dept. of Energy review processes. In my opinion this indicates a willingness by Congress to promote the exporting of natural gas.

A Global Perspective on Natural Gas Prices

US Natural Gas Import/Export Locations as of 12/31/2008

Converting an LNG import facility to an export facility is not as simple as flipping a switch. Lots of permitting (read: government revenue) is required, including engineering studies and environmental impact reports; and retooling the import facilities will take time and money, lots of money.

The US is capable of becoming a net exporter of energy, thereby promoting jobs and GDP growth for years to come. The resources are within our grasp to enhance tax revenues and help pay for the future expenses of Social Security and healthcare. And I am not even discussing the potential for further oil exploration beneath federal lands such as ANWAR in Alaska. Before I get the environmentalists screaming that all oil companies are evil, hydraulic fracturing should be banned, and the potential contamination of groundwater outweighs the merits of providing healthcare and Social Security benefits to our citizens, I need to state that I am not a chemical engineer. I have limited understanding of the issues involved in fracking, offshore drilling, and drilling on federal lands. I acknowledge there are right ways and wrong ways for things to be done. Corporations will cut corners and EPA enforcers will overreact, but we have to find ways to compromise. There is a tremendous opportunity for the US to right its fiscal ship without taxing the general populace out of their homes. For without the revenues and jobs that future oil and gas exports could bring, I do not see a way out of the systemic mess the last 50 years of misguided federal spending have gotten us into.

Main Street is not sharing in the wealth of Wall Street. While the Dow sits at all-time highs, most of Main Street still suffers from high rates of unemployment, with future layoffs coming in the wake of the sequestration and declining consumer spending from higher taxes that kicked in on January 1, 2013. Main Street investors also have not participated in the rise of stocks over the last five years, as shown by this chart from Ryan Detrick:

Wall Street is getting richer; Main Street is getting poorer. This is an unintended consequence of the Fed’s zero-interest-rate policy. Low interest rates have killed middle- and lower-income retirees and savers, as they don’t think they can afford the risks of stocks, yet CDs and other “safe-yield” vehicles give them only a fraction of the income they earned from investments five years ago. I see nothing in the policies of the President, Congress, or the Federal Reserve that is going to change the continuously widening separation between the wealthy and the poor in this country.

Summary

In our opinion, in the current economic environment, yields simply cannot go any lower. Austerity policies will persist in Europe and eventually come to the US. The Fed stimulus has lost its ability to impact unemployment; and the economy is running out of steam, because consumer spending is being hit as a result of the FICA and Obamacare tax increases that went into effect on January 1.

We will remain disciplined in our approach to the markets, as protection of principal and the recognition of risks are the foundation of our process. Our tactical allocation process does have a “value” bias, and while this has its virtues, very few people have the temperament to stay disciplined. The reason they don’t is that, when you take this approach, there will be times when others are making more money than you, and while you’re at the plate patiently waiting for the fat investment pitch, the owners and fans are screaming, “Swing, you bum!” To endure the ridicule of not keeping up with the market and to lose business in the process is never easy. It is particularly challenging to connect with the arc of opportunity in today’s environment, with the ever-shifting winds of regulatory policy, tax and monetary policy, and currency wars that reshuffle the scoreboard of winners and losers on a monthly basis. Discipline and patience are tough to maintain when the markets are snorting monetary cocaine, ignoring valuations, ignoring inept governments, and embracing risk to avoid earning zilch in money markets and short-term “safe” investments. At Excelsia, we will stay the course. Good luck out there.

Cliff

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment-related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Excelsia, Inc. is neither a law firm nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.

Woke up this morning, my head was so bad The worst hangover that I ever had What happened to me last night That girl of mine, she loved me so right (yeah!) (oh, oh) She loved me so long and she loved me so hard

I finally passed out in her front yard (whoo!) It wasn’t wine that I had too much of It was a double shot of my baby’s love

Double shot of my baby’s love, yeah yeah, yeah Double shot of my baby’s love, yeah yeah, yeah A potion that I had too much of It was a double shot of my baby’s love

QE3 and Unintended Consequences

The Ben Bernanke and Mario Draghi concert gave the markets a double shot of their love in the month of September by promising to print as much money as needed to finance the debts of their respective countries. Ever since the financial fraternity party ended in 2008 and the world began deleveraging its massive credit hangover, the global markets have been hooked on the next shot of love from the central bankers. The Fed plans to purchase $40 billion a month of mortgage-backed securities for an unlimited time period; that’s over $480 billion a year. Draghi gave us his “Outright Monetary Transaction” (OMT) bond buying plan. The ECB’s bazooka-ready program alleviated the fears of an imminent euro breakdown. The

looming defaults of Spain and Greece are seemingly under control, with the backing of the ECB. And, the ruling from the Federal Constitutional Court of Germany that supports Germany’s participation in the ECB allowed Draghi to successfully kick the euro crisis down the road for who knows how long. I agree that Draghi needed to buy time in order for the Germans to decide how they will handle a continued euro union. But did Bernanke and Company really need to implement QE3 at this time?

The graph above is the balance sheet of the Federal Reserve. It demonstrates the explosion in long-term Treasury and mortgage- backed securities purchases that began in 2009 at the height of the financial crisis. The Federal Reserve has exploded its balance sheet over the past four years in order to make absolutely sure that interest rates in the market stay low. The Fed is accomplishing this objective by creating dollars from thin air – mere entries on the computer. Individuals and corporations can work years to amass wealth, but with one journal entry the Federal Reserve can create 1000 times what the private sector can do through hard work and sweat. The message is clear, in that The Fed will print any amount of money needed to finance out-of-control government spending and protect our Humpty- Dumpty, too-big-to-fall-off-the-wall bankers.

What makes this problem worse (an unintended consequence) is that, when politicians know that the central banker will continue to hide real problems, they are less inclined to do anything regarding fiscal reform and getting government budgets under control. As an example, the day after Bernanke announced QE3 on September 13th, the House

passed a stopgap budget of $1.047 trillion dollars, and I did not see one mention of this action in the financial press. Our government has been without a budget for the fourth consecutive year, and the stopgap measure was passed because no one in Capitol Hill can agree on anything other than getting re-elected. And with Bernanke’s QE Infinity plan, our political leaders are content with a do-nothing Congress where uncontrolled spending will continue.

There is no recent history lesson that can prepare us for what lies ahead, other than the hyperinflation of the Weimar Republic. During the hyperinflation, German economists, ala Paul Krugman, continued to advise the government that the money supply was not growing fast enough. In the US today, money is growing at a faster rate than ever before, but the velocity of money has declined just as quickly. The Federal Reserve’s QE1, QE2, and Twist merely replaced the trillions of dollars lost in the crisis of 2008. The velocity of money moving through the system continues to drop, as illustrated in the next chart. Corporations, banks, and individuals are still repairing their respective balance sheets; and with the political uncertainty of the future regulatory environment and the fiscal cliff on the horizon, no one is willing to do anything but sit on their cash.

The other unintended consequence of the Fed’s most recent action will produce the worst possible outcome. Rich people will get richer, because they own stocks, which should act as an inflation hedge ala 1976 to 1980. Poor people will get poorer, because QE3 will not produce jobs and they will pay higher food and gasoline costs while at the same time facing lower real wages due to global competitive pressures. We are going to experience inflation in those utilities we require (food, energy, medical, etc.) and deflation in those things we don’t need (housing and home prices, durable goods, etc.); and there will eventually be an end game to the dual-entry expansion of fiat currencies around the world.

Given the unprecedented amount of government debt as a percentage of GDP, how can we protect our assets in order to not lose dollars in either nominal or real terms?

We remain very positive towards commodity-driven assets, either in the form of stocks, the actual commodities, or participation in private equity funds where the focus is on some type of real asset. Farmland, timber REITs, oil and gas MLPs, fertilizers, agricultural suppliers, and gold and gold mining stocks would be at the top of our list. The following chart is from Fidelity Management:

Gold vs. Central Bank Balance Sheet:

No one can foresee the future, but the world is caught in a Keynesian epidemic of central bankers who seemingly believe they can print their way to prosperity. In my opinion, there is a battle looming between hard currencies and fiat currencies. The chart above illustrates the combined balance sheets of the six largest central banks (Fed, ECB, Peoples Bank of China, Bank of England, Bank of Japan, and Swiss National Bank) and the correlation to the price of gold. The world is still deleveraging, and for now inflation seems to be benign. However, if the Fed and other central banks go sliding down the slippery slope of confidence erosion and debt monetization, then owning hard currencies will be an effective method to at least maintain your purchasing power.

Who gets hurt in an inflationary scenario: fixed-income investors and purchasers of bonds. The Investment Company Institute provides the following data regarding mutual fund flows in and out of stocks and bonds over the last five weeks:

Estimated Flows to Long-Term Mutual Funds

Millions of dollars

8/29/2012

9/5/2012

9/12/2012

9/19/2012

9/26/2012

Total Equity

-4,493

-3,453

-3,366

-5,115

-7,497

Domestic

-3,690

-3,223

-2,809

-4,759

-5,082

World

-803

-230

-557

-355

-2,415

Hybrid

870

914

1,306

1,635

-377

Total Bond

6,380

4,903

8,106

7,996

8,322

Taxable

5,384

4,159

6,794

7,550

6,885

Municipal

997

743

1313

446

1,437

Total

2,758

2,363

6,047

4,516

448

At the very time when real risks of losing money in fixed income are the greatest, the investing public and, I suspect, the 78.1 million Baby Boomers who will retire in the next 15 years have become so gun shy of stocks that they are seeking what they assume to be the safety of bonds. In our opinion the Fed and other central bankers have created another financial bubble in the bond markets by artificially holding down interest rates through massive government intervention. And yet we are reminded again the old adage “Don’t Fight the Fed.” The chart below from caseyresearch.com illustrates how the equity markets have reacted to QE1, QE2, and Operation Twist … and now they have another shot of Bernanke’s love. Can you feel the love?

Elections, Unemployment, and A Divided Nation

The convoluted methods employed by the Bureau of Labor Statistics can be confusing to the average investor. And surely the person who has been unemployed for over a year does not believe things are getting better. There are two surveys used in computing unemployment:

Establishment Survey – polls 400,000 companies about the number of employees they have and separates part-time versus full time along with income data.

Household Survey – polls 60,000 households each month to see how many live in the household, whether anyone is working, and whether they have part-time or full-time jobs.

The BLS is not corrupt, nor do I think it manipulative, as Mr. Welch suggests; he did far more manipulating of GE’s earnings during his career, in order to show continued positive growth for over 20 years. However, I would refer you to the chart above from John Williams of Shadow Stats, who calculated his own unemployment number, using the methods employed by the BLS during the 1980s, to be at 22%. While the recent U3 measure shows a decline to 7.8%, I know of no one hiring full-time employees and would opine that unemployment is indeed higher than the reported 7.8%. Need proof? Then take a look at the growth in the number of people on food stamps:

If you have a job, you tend not to need food stamps (or, as they were rebranded in October of 2008: SNAPs – Supplemental Nutrition Assistance Program).

Regardless of what happens on November 6th, our country will remain much divided, based on socioeconomic, race, and religious differences. Our economy is at a tipping point where the amount of debt is approaching Reinhart and Rogoff’s critical measure of 90% of GDP (This Time Is Different; Eight Centuries of Financial Folly). In their studies, Reinhart and Rogoff found very little association between public debt and growth for debt levels of less than 90% of GDP. But debt burdens above 90 percent of GDP were associated with a 1 percent lower median growth rate per year – and that would be a killer to the US economy. Their results were based on a data set of the public debt of 44 countries covering 200 years of time, and their results support the contention that government debt hinders the ability to grow. If our country has the inability to grow its economy and jobs, then we will enter the spiral of entrapment that Greece and Spain are experiencing today. The debt has to be addressed.

No one knows what the outcome of our elections will be on November 6th. From our perspective, an Obama win would predicate another two years of stalemate, as it is doubtful the Democrats will win enough seats in the House to overturn the current Republican majority. Perhaps there will be some renewed sense of compromise for the good of the country and reason will again enter the equation, but I sort of doubt it. With Obama in office for four more years, we will go over the fiscal cliff with the same attitude we held as we entered the debt- ceiling debate of August of 2011, with neither side giving ground.

If Romney were to win, it could be a short-term game changer in terms of restoring confidence in corporate America and investors. Our current path is clearly not sustainable, with four years of trillion-dollar deficits, 23 million unemployed, and a surging populace dependent on food stamps and Obama cell phones. This is not a political statement, it is simply stating the fact that the policies of overly big governments are inherently flawed.

We are working diligently to plan a “risk on” strategy should there be a change in the White House; but given that this election is a tossup, anyone willing to make big bets on the outcome would be better off in Vegas. By the way, last week’s edition of The Economist (October 6-12 2012) has one of the best summaries I’ve seen regarding the similarities and differences of Obama versus Romney, and I encourage you to get a copy and read the articles.

Wars, Food, and Global Leadership

“Political power grows out of the barrel of a gun.” –Mao Tse-tung

“Being powerful is like being a lady. If you have to tell people you are, you aren’t.” –Margaret Thatcher.

I finally finished reading Ian Bremmer’s most recent book, Every Nation for Itself: Winners and Losers in a G-Zero World. I recommend anyone who is concerned about the future vacuum of global leadership to definitely read G-Zero. Bremmer asserts that the G-Zero has supplanted the G7 and G20 as the world’s international order. The effect is that no one country has the ability to impose its will to forge a common approach with other countries regarding issues such as food shortages, energy crises, global warming, pollution controls, or water resources.

The United States lacks the resources to continue as the global provider of public goods, Europe is absorbed with making sure the euro survives, Japan’s debt is now 200% of its GDP, and China has no interest in accepting the responsibilities that come with international leadership. Bremmer contends that the result will be intensified international conflict.

However, all is not yet lost, as evidenced by the effects international sanctions are having on Iran. Iran’s currency, the rial, is down over 50% in recent weeks versus the dollar, which must be making the Ayatollah say Holy molla! By freezing Iran out of the global banking system and banning European oil sales (which the German’s don’t miss right now, in light of Europe’s recession) the world has effectively reduced Iran’s oil income, which is causing the cost of buying a chicken to do the daily double, if people can even find one. The Iranian government under Ahmadinejad is being subjected to questioning and angry demonstrations, with the inflation estimate for Iran at 100%. When people lose faith in a country’s leadership and currency, then it’s an unbelievably quick fall into the financial abyss. And when the financial abyss equals food shortages and starving people, then a change is coming.

I predict that food will supplant energy as the crucial resource for the Middle Eastern countries. Lack of arable land and fresh water, as compared to North and South America or Europe, will eventually hinder the birth/growth rates of the Muslim world. Click the following link:

Jeremy Grantham, in his methodical style, does an excellent presentation on “Dystopia.”

Summary

In our January newsletter, Doing Nothing – Nothing Done, I had four focus points:

Germany’s Euro

Inflation versus Deflation

Election Year

It Isn’t All Bad

In the section “It Isn’t All Bad” I stated, “Despite the problems of the euro, the continued printing of fiat currency by central bankers, and a US government at the helm of a rudderless ship, the corporate world continues to bang out profits and capitalize on global growth. Looking at the following charts one would assess that the large multinational US corporations will survive regardless of what happens in Europe or the US.”

“Corporate cash is at all-time highs and dividend-payout ratios are the lowest in ten years; and if governement would get out of the way, we would see a return of capital expenditures. I make the argument that with valuations at these levels, high-quality US multinational corporations with strong dividend histories will prove a better investment over the next five years than a ten-year or thirty-year treasury. In the short term, with the potential for euro breakdown and other geopolitical risks, the flight to safety in US treasuries may enable bonds to outperform stocks. During this time, fear will trump valuations. Long-term (3-5 years), equities outperform treasuries.”

There remain on the horizon some big-time political risks for the markets: election results, the euro’s outcome, the fiscal cliff, debt and more debt, and the continuation of a deleveraging process that began in 2008 and will probably run to 2017. We are becoming more cautious as we approach 2013, due to the fact that no one can predict with any degree of certainty where the political leaders and the central bankers are headed. At Excelsia we will remain committed to the Global Tactical Asset Allocation discipline that has served us well in difficult times over the past 20 years. Here’s to you keeping your portfolio between the ditches.

Good luck out there, Cliff

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly above (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information referenced above serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

]]>http://www.excelsia.com/2012/10/investment-outlook-2013-abcd-investing-anything-bernanke-cannot-destroy/feed/0Game of Throneshttp://www.excelsia.com/2012/07/game-of-thrones/
http://www.excelsia.com/2012/07/game-of-thrones/#commentsThu, 12 Jul 2012 15:56:42 +0000http://www.excelsia.com/?p=1080“Today, the stock prices of the largest US banks are about as low as they were in the early part of 2009, not because of euro-contagion or Super-committee super-incompetence (a useless distraction anyway) but because of the ongoing transparency void surrounding the biggest banks amidst their central-bank-covered risks, and the political hot potato of how many emergency loans are required to keep them afloat at any given moment. Because investors don’t know their true exposures, any more than in early 2009. Because US banks catalyzed the global crisis that is currently manifesting itself in Europe. Because there never was a separate US housing crisis and European debt crisis. Instead, there is a worldwide, systemic, unregulated, uncontained, rapacious need for the most powerful banks and financial institutions to leverage whatever could be leveraged in whatever forms it could be leveraged in. So, now we’re just barely in the second quarter of the game of thrones, where the big banks are the kings, the ECB, IMF and the Fed are the money supply, and the populations are the powerless serfs. Yeah, let’s play the ECB inflation game, while the world crumbles.” – Nomi Prins

Sick of it!

Have you had enough of Greece? Spain? The euro and contagion risk? Bailouts? Are you tired of waking up each morning to watch the stock, bond, and currency markets turn tipsy over whether German Chancellor Merkel is having a good day or a bad day? Do you really care if they throw Greece out of the euro? Aren’t you just being worn down by the daily Leveche winds out of Spain? Or, if the euro and the future of Europe are of no interest, then has the toxic US political arena fouled the air around you? Are you fed up with the plundering and pillaging of the national treasury by Wall Street bankers? Do you believe Jamie Dimon still thinks a $2-8 billion-dollar trade loss was a hedge? Do lies, damn lies, and LIBOR interest-rate manipulation by the world’s biggest banks give you any degree of comfort that bankers are looking out for anyone’s interests except their own? Has the whole world filled with cheats and political opportunists? Have US citizens gotten so apathetic that we are willfully choosing ignorance over critical thinking? Is the average person more concerned about next week’s episode of The Voice and keeping up with the Kardashians – as opposed, say, to understanding the calamitous future that 40 years of continuous government expansion has consigned us to? The latest smooth move being a Supreme Court decision that a penalty is not a penalty but another form of tax, permissible under the Constitution.

But if that’s not enough, then let’s throw in the complexities of a Muslim Brotherhood takeover of the Middle East. Egypt just elected President Mohamed Morsi, who states, “The Koran is our constitution, the Prophet is our leader, jihad is our path, and death in the name of Allah is our goal.” Think Israel is listening? What does he mean by “death in the name of Allah is our goal”? Toss in a nuclear-capable Iran and things in the Middle East begin to get real interesting.

Not enough?

Then are you sick of the continued deleveraging of real estate? The latest episode of Government Going Bad features a proposal by the states to use their right of eminent domain to force compulsory purchases of underwater mortgages in an effort to force mortgage holders (banks) to restructure the terms of the mortgages. Wait, haven’t we (the US taxpayers) just bailed the banking industry out of a multi-trillion-dollar hole? And now the states are going to force more losses on the poor bankers? Who’s the captain of this ship?

It gets better: Americans are getting poorer. Simply look at the change of net worth in the US, broken down by age, from 2007 to 2010:

And with this loss, middle-class Americans are beginning to realize that life as they knew it has changed. The bubble burst in 2008; and while a number of Americans are still in denial, the deleveraging of the consumer and the world will be here for years to come. The last major deleveraging in America occurred from 1933-1938, and it took a world war to propel us back to productivity. Americans are becoming ever more frustrated and are smart enough to know they have been had – they just aren’t sure whom they’ve been had by. Was it government policy? A deaf, dumb, and blind Federal Reserve? Or those greedy Wall Street bankers?

“Experience has shown that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny.” – Thomas Jefferson

The decline in net worth is largely a result of the collapse in real estate, but many who lost from their 401k’s and other savings have not returned to stocks, as evidenced in the following chart from Bianco Research:

As you can see, since 2008 investors have relentlessly sold their domestic stock mutual funds. There is the argument that individuals and institutions replaced their mutual funds with the more flexible and often less expensive ETFs, but I can find no data to support this premise. My interpretation of the net exodus of investors from equity funds is that it is a flight to income and a flight to safety.
Last week saw yet another anemic unemployment report. As usual, it was badly distorted, because of the way the Labor Department elects to calculate the numbers. From John Williams of Shadowstats we have the following more accurate look at unemployment in the country. (The “SGS Alternate” is Williams’ line.)

Sick of it? Yes, my opening rant was meant to get your attention and convey why I think the business world and investors are experiencing such angst in today’s world. From the CEOs of multinational corporations to the mom and pop shops across America, we all face the same fundamental dilemma: what are the governments of this world going to do to us next? We don’t live in an investment world predicated on earnings, growth, and valuations; they have been replaced by quantitative easing, bailouts, and contagion risk.

An economy consists of a gazillion simple transactions, all working together; and our economy used to be grounded is such factors such as supply and demand, growth, and imports and exports. But today the economy is driven by the political rhetoric of our elected officials as it relates to regulations, taxes, and anticipation of QE3. Investors are frustrated in this economic environment, because the rules we played by during the halcyon years of expanding debt in an inflationary world no longer apply in a deleveraging world. We are in global slowdown mode, and to understand how we should invest we need to better understand what deleveraging will mean over the coming three- to five-year period.

A Deleveraging World

Deleveraging is the process of reducing debt via debt monetization, debt reduction, or austerity. Although few have been willing to say it, America and other global economies have been fighting a potential depression, not just a “great recession.” Recessions are caused by an oversupply of goods and services, and have sometimes occurred when government central banks put the brakes on an overly expansive economy by simply raising interest rates. Depressions, however, are periods when debtors, on a grand scale, owe more than they can possibly pay, and when central-bank monetary policy is no longer effective in creating credit or lowering borrowing costs. When interest rates get to zero, the Federal Reserve becomes ineffective at stimulating demand. Simply look at the following two charts, and you can see that, although the Federal Reserve has significantly increased the amount of money in our system and lowered rates to zero, the velocity at which money is circulating through the system has consistently declined since the onset of the secular bear market that began with the NASDAQ/tech bubble burst in 2000.

Although deleveraging can occur without a depression, the key is how governments behave.

The US economic system is based on our ability to purchase goods and services with either money or credit. In years past our system worked well, because there was an abundance of investors and lenders were willing to exchange their capital with borrowers and sellers, based on the premise that the borrower would pay the lender in an amount that was more than the original principal borrowed. Both the borrower and the lender believed the transactions were good for them. In the present era, however, while the amount of fiat money is controlled by the Federal Reserve, credit can be created out of thin air between two parties – credit default swaps are a prime example. The one major limitation on credit was found in the banking industry, where there were reasonably effective controls over how the credit process worked. However, the repeal of Glass-Steagall in 1999 gave US banks the ability to bypass those controls, and credit exploded in the form of mortgage securitizations.

And then the bubble burst. The credit expansion cycle that began in 1938 ended in 2008, and with it middle-class Americans’ ability to continue to spend as though their wages would continue to rise. Since 2000 the level of household income in the US has deteriorated, but the baby boomer generation wanted the lifestyle of their retired, fully pensioned parents. Boomers did not achieve it by increasing their incomes but by turning their homes into ATM machines. The evidence of the borrowing is seen in the chart above, and the deterioration of wages is evidenced in the chart below.

During the expanding-credit years of the debt super cycle, the Federal Reserve controlled expansions and recessions by manipulating the cost of borrowing. The Federal Reserve exacerbated the severe pain of 2008 by artificially manipulating rates to lower levels from 1998 to 2008. While the amount of debt consumers hold is important, it is more important that they can make their house and car payments. When rates decline it is possible for individuals and companies to add more debt, since the amount of debt service is declining. The long-term debt cycle ends when debt and debt-service levels are so high relative to incomes that the Federal Reserve is unable to produce credit growth. From that point forward, households, businesses, and banks default on their debt or cut costs, and that causes other problems such as high unemployment and low GDP growth. It is at this point that the central bankers pull out all stops to prevent a depression, but they can’t take interest rates any lower than zero, and as a result they lose the ability to ride to the rescue.

However, the debts remain to be paid by whatever means; and a cycle of asset-price declines, lower incomes, and reduction of credit begins and runs its course in a self-reinforcing contraction cycle. As a result, a big factor in deleveraging is the consumer’s realization that credit is not money and what they thought was wealth has shrunk or is no longer there. The psychological outcome of deleveraging is that the tension between the “haves” and the “have nots” increases; and then political rhetoric about taxing the rich emerges, and organizations such as Occupy Wall Street are formed. In boom times everyone is a capitalist; in busts everyone becomes a socialist. The fear that the government will tax away investors’ gains or there will be other calamitous developments during the coming decade of deleveraging and recovery is where we find ourselves today; and that is the context in which we must determine our course of action in preserving and increasing wealth.

Depression Investing

During the Great Depression there were six big rallies in the stock market, with gains between 21% and 48% that were all triggered by government actions not unlike those we have seen recently, such as QE2, Operation Twist, bailouts, and tax reform. As the chart below shows, it’s a very choppy ride, with markets seemingly turning on a dime each time the government takes action.

The investment issue is that what worked in the past, using a buy-and-hold, 60% stocks and 40% bonds portfolio, will not work for depression investing. If you want to pursue a traditional portfolio, then the following chart by my friend Rob Arnott at Research Affiliates gives excellent guidance as to what your return expectations should be for the next ten years: 4.4% per year.

Why 4.4%? The calculation is based on beginning dividend yields, with a mean EPS growth factor and implied inflation that, added together, give you an expected equity return. The bond yield is whatever the ten year treasury is yielding. By taking 60% of the expected return on stocks and adding 40% of the expected return on bonds, you get the column of Expected 60/40 Return. It is astounding how close the expected rates of return are to the realized rates. And note that 4.4% is the lowest expected annual return for any ten-year period … ever. I thank Research Affiliates for these insights.

If you elect the traditional buy/hold, then I suggest you may be caught in the psychology of “depressing investing,” since your returns will be nominal, even as volatility inexorably rises. The correlation of US stocks to emerging-market stocks to EAFE stocks has converged significantly over the last 20 years. Combine those higher correlations with the impact of high-frequency traders (they account for 77% of all trades, according to Jonathan Brogaard), and I can make the case that higher levels of volatility in the marketplace are here to stay.

So, if you’re not satisfied with modest returns coupled with higher levels of risk, what should you do? You have to Think Differently!

First, you need to understand the risks associated with today’s bond market. The following chart depicts the potential impacts of rising rates for investors who hold ten-year or thirty-year bonds:

The only case where I could see holding significant amounts of 10-year and 30-year US bonds would be if there was the expectation of another financial crisis. One that would be larger and more damaging than 2008 and would involve the financial system on a global basis, not just in the US. Otherwise the continued printing of fiat currencies by most of the major developed nations will eventually lead to inflation and higher rates, resulting in bond-market losses. Keep your eye on the Federal Reserve.

Second, when constructing your portfolio, you need to implement a certain level of alternative fund investments such as mezzanine debt, private equity, commodities, long/short, and real estate. There is no asset-allocation model that can dictate how much exposure you need, due to the amount of survivor bias and non-reporting of results that exist in this arena. At Excelsia, we have found a number of funds, publicly traded and private LPs that have provided our investors with double-digit rates of return. In our opinion, the right allocation amount depends on each client’s capitalization and investment needs; however, a good rule of thumb would be a minimum of 5% to a maximum of 35% devoted to “alternative” investments.

Third, the remainder of your portfolio needs to be managed with tactical discipline, as opposed to a traditional buy-and-hold approach. A secular bear market combined with a deleveraging credit cycle lasts on average about 17 years, and while we are closer today to the end of this bear than we are to the beginning, we still have a ways to go. At Excelsia, we reallocate among the nine different asset classes on a quarterly basis, in the attempt to manage risk-on/risk-off.

While we have seen some troubling weakness in the recent U.S. employment reports, the bigger risk for us is Europe going from bad to worse, leading the U.S. to a mild recession. In my opinion, the stock sell-off in Q2 2012 reflected the market’s expectation of Europe getting worse. After all, stocks are leading indicators of economic events. The second-quarter decline and weak economic results should give way to another round of quantitative easing – QE3 – that could create a second-half advance. We cannot ignore the political pressures of an election year, and the history of markets in relation to election cycles would suggests a positive finish to this election-year cycle. Add to this the recent upturn in NDR crowd sentiment, shown in the chart below, and the remainder of the year should prove to be positive rather than negative for the equity markets.

The themes have not changed. I further stated that you would reside in one of two investments camps for 2012:

Camp Optimist

Eurozone is maintained

Global GDP grows 3-5%

Europe has a mild recession

Financial contagion is limited

US and other nations continue stimulus policies

Camp Pessimist

Germany loses the game of chicken; euro breaks apart

Widespread financial crisis from the detonation of the neutron bomb of the financial world: credit default swaps

US ceases stimulus programs in favor of more austerity

Global recession

The single biggest risk today for a downward turn in the equity markets is Europe. The lack of governmental ability to create money and credit is the Achilles heel of the euro; there simply does not exist a true central bank. Creation of a European Banking Authority is at the center of Europe’s scramble to survive the deleveraging cycle the developed economies now face. On June 29th eurozone countries agreed that the European Stability Mechanism (ESM) would replace the ESFS as facilitator and have the power to recapitalize eurozone banks directly. The 27 nations whirling around somehow caught Germany in a game of pickle, and Merkel was tagged out trying to get back to first base and conceded that she would support the proposal. At the end of the day, I remain in Camp Optimist for now, as Germany will make concessions to maintain the euro; it’s simply a big, expensive Game of Thrones being played out.

Good luck out there.

Cliff

PS. The following chart has absolutely nothing to do with this commentary. I just thought it interesting to see over time the balance of power, based on combined GDP, and the projected balance of power going forward. Look what happens to India.

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly above (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information referenced above serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

]]>http://www.excelsia.com/2012/07/game-of-thrones/feed/0The Monthly Market Monitor – May 6, 2012http://www.excelsia.com/2012/05/the-monthly-market-monitor-may-6-2012/
http://www.excelsia.com/2012/05/the-monthly-market-monitor-may-6-2012/#commentsTue, 08 May 2012 14:17:10 +0000http://www.excelsia.com/?p=1060“What’s right about America is that although we have a mess of problems, we have great capacity – intellect and resources – to do something about it.” Henry Ford II (1917-1987)

“The perfect beaureaucrat everywhere is the man who manages to make no decisions and escape all responsibility.” – Brooks Atkinson (1894-1984)

Despite strong market performance year-to-date in the stock market, there remains clear and present dangers on the horizon. These uncertainties have caused jitters in the market recently, as depicted in the attached performance chart (Exhibit 1). As the quote from “Hank the Deuce” above states, though we have a mess of problems, we have to do something about it. We currently have the time, the means and the capacity. It may hurt to fix the fiscal messes we face, but the alternatives will be much harsher (just ask the Greeks). You may have heard about a US “fiscal cliff” recently, but it has not garnered the type of headlines it perhaps deserves. This year is an all-important election year. But perhaps more importantly, as we ring in a new year January 1, 2013, there are a number of issues that will become front and center, and how they are handled will likely dictate the direction of the economy and capital markets alike.

The Bush tax cuts, if left to expire, coupled with the implementation of surcharges related to the president’s new healthcare law, will mean that dividends will be taxed at 43.4%, up from 15% today (dividend tax rate would revert to 39.6% plus the healthcare surtax of 3.8% on all investment income, including dividends). For the record, pensions do not pay this tax and most corporations have a 70% exclusion on dividend income, so the real hit will come to the individual investor. The full payroll tax would be reinstated which would means less cash in the pockets of consumers, which are already feeling the pinch at the gas pump and the grocery store. Also, the debt ceiling debacle has not been resolved and will trigger further tax increases and government spending cuts, which should be done more surgically as opposed to the across the board brush as a result of inaction on the part of Washington.

The US has serious challenges ahead and the ensuing sacrifices will be painful. We can only hope the second quote from Brooks Atkinson above is not the game plan in Washington. To allow these events to occur while pointing the finger at each other will be a complete dereliction of duty for anyone remotely tied to the Washington scene. There must be chills going down the backs of politicians as they watch elections in France and Europe and see incumbents thrown to the curb. Herein lies their conundrum: do what’s right for the country or do what’s right for their re-election chances.

The US economy has been stronger relative to Europe and the UK, as a number of these countries are either in recession or very close. However, the strength is only relative and as I pointed out last month, the reported numbers should always be taken with a “grain of salt”. While the unemployment rate in April did drop from 8.2% to 8.1%, it should be noted that at least part of the explanation is that 342k people left the workforce and were not counted by the Bureau of Labor Statisics (BLS) (ie, they vanished in the eyes of the BLS). The labor force participation rate has dropped to 63.6%, the lowest level since 1981. For those who are employed, wage growth has been sluggish at best and certainly not exceeding inflation.

While I have been rather cynical thus far, it is more to temper expectations. The economy is growing and we are closer to the bottom in housing than we were last year (see, I can be optimistic!). I am just offering a reminder that we have seen unprecedented central bank involvement both here and abroad. The new phenomenon of “cyber-printing” of money that needs no ink or paper has emboldened many at the behest of the Fed to take more risk and shift the chairs on the deck of the debt-laden Titanic. These central bank actions are not without consequences. The graph below shows the sharp upward movement of money supply, which can be attributed to the Fed flooding the system with the “cyber-printing” of dollars. The declining line is the change in the velocity of money, or how much is actually being used in the system (the second chart depicts the absolute level of the velocity of money). This portends inflation. We may not get there this year or even next depending on the outcome and level of potential calamity with events that are plaguing the world today. But once this money is unleashed, inflation will rear its ugly head.

M2 Money Supply and M2 Velocity of MoneySource: Bloomberg

When this happens, the proud buyers of US Treasury bonds will be swimming in losses (this will also happen once the Fed ceases to be the major buyer in this market, ala end to QE, Operation Twist, etc.). It is true that stocks may very well serve as an inflation hedge to a degree, but it seems logical that resources in the ground will play a large part in hedging the inflationary consequences of the free-wielding Fed and other central banks (US, ECB, Bank of Japan). For example, we have been bullish on gold for some time and continue to be. Diddo for the gold miners, who have been getting cheaper recently, which we happen to like. I believe we will continue to see strong results from these companies, including shareholder returns through increasing dividends, though we will stay tuned to potential tax law changes, as described above.

For the remainder of the year, the uncertain geopolitical risks will continue to dominate the headllines. Corporate America continues to surprise to the upside, with earnings thus far up between 5-10% in the first quarter. These companies also continue to build their war chest of cash due to the uncertainty in the political arena, with potential regulatory and fiscal changes that make committing to certain projects unfeasible at this time.

Exhibit 1 (Returns are Price Only through May 4, 2012)Source: Bloomberg

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